International economic conditions have weakened in recent months and are likely to
provide a less favourable environment for the Australian economy in the coming
year. The United States in particular is now in a period of considerably slower
growth, and this has prompted a broader reassessment of international economic
prospects, with most observers in recent months revising downward their expectations
for global growth. This shift in expectations has been reinforced by renewed
concerns about the durability of economic recovery in Japan.

The slowing now under way in the US economy comes after a period of exceptional strength,
both in terms of the length of the economic expansion to date and the average
pace of growth recorded in the past few years, with growth being particularly
strong in the first half of 2000. Some easing in the earlier pace of growth
was widely seen to be desirable to forestall a further rise in inflation, and
monetary policy in the US had been tightened in late 1999 and 2000 with that
goal in mind. The majority of forecasters had repeatedly anticipated a slowing
during the past several years, but it took much longer to occur than most had
expected. The slowing did finally begin during the second half of 2000, and
in contrast to the experience in earlier years, most observers have recently
found the data on the US economy to be weaker than they had expected.

Financial market developments have played an increasingly important role in shaping
US economic performance in recent years, both adding impetus to growth through
much of the second half of the 1990s and more recently dampening demand. Broad
share-market indices in the US peaked in early 2000 and have since declined
by around 15 per cent, while ‘technology’ stocks have declined
much more sharply. Falling share prices appear to have made households in the
US more reluctant to increase their spending, as well as discouraging equity-raising
by businesses. At the same time, credit market conditions have tightened, making
it more difficult for US firms to obtain funds for investment from that source.

There is at present, therefore, a good deal of uncertainty about the near-term prospects
for the US economy. The various contractionary forces could combine in a way
which continues to push US growth down very markedly. Alternatively, after
a temporary weak period growth could firm later in the year. The recent interest
rate reductions by the Federal Reserve will increase the likelihood of the
latter outcome, but it is too soon at present to discount altogether the possibility
of the former.

The Australian economy has also slowed in recent months, although for somewhat different
reasons than the US. GDP growth in the September quarter (the latest period
for which the accounts are available) was weaker than it had been in June,
both on a quarterly and year-ended basis, although growth was still over 4
per cent over the year. More recent indicators, however, point to only a moderate
pace of growth in the latter part of the year and into the early part of 2001,
with domestic demand running much more slowly than it had done in the preceding
year, and the labour market turning in a noticeably softer performance. Strong
growth in exports has continued to provide a partial offset to the weakness
in domestic demand. Exports have continued to benefit from the low Australian
dollar and, despite the easing in trading partner growth towards the end of
the year, the value of exports in the December quarter was 27 per cent higher
than a year earlier. This trend has also led to a substantial narrowing of
Australia's current account deficit.

A number of factors of a temporary nature have affected the recent pattern in domestic
demand in Australia. The introduction of the new tax system created a strong
incentive for households to shift expenditures from the second half into the
first half of 2000. This was most strikingly evident in the case of housing
investment, which contributed strongly to growth in the first half of the year,
pushing spending on housing construction to an all-time high as a share of
GDP. This was followed, in the September quarter, by the largest quarterly
decline in housing activity in the period for which records are available,
which reduced GDP in the September quarter by more than a percentage point.
The introduction of the GST also shifted some retail spending into the first
half of the year, although the impact was much
smaller in magnitude than was the case for housing. There are some reports
by industry groups of other transitional issues associated with changes in
the tax system.

The factors above should largely be confined to affecting the timing of spending,
but even apart from these effects, the underlying trend in domestic demand
has moderated. Several forces have been at work in bringing this about. Higher
oil prices have reduced consumer purchasing power, although these have been
partly reversed. The strong gains in household wealth in recent years, which
supported consumption growth, have lessened considerably, since house prices
are no longer rising and share market gains have been more subdued. In addition,
interest rates have increased, which will have reduced funds available for
household spending of a discretionary nature.

As is detailed in the body of the Statement, however, financial conditions in Australia do not appear
to be as restrictive as they are in the US. The rise in interest rates in Australia
brought them to levels well below their mid 1990s
peak; in the US they exceeded it. Credit growth – while slowing a little
– remains quite strong, and there is no evidence of a significant decline
in credit availability in capital markets. The US experience is quite different.
Although share markets in Australia have to some extent taken their lead from
the US, the run-up in Australian share prices in the late 1990s was never as
large, and the softer performance over the past year or so has been much less
pronounced. Indeed, share prices in Australia have increased slightly over
the past year while those in the US have been declining. The Australian dollar
exchange rate, while higher than it was in late 2000, remains at historically
low levels, and therefore supportive of activity, in contrast to the strong
US dollar.

There is also an absence of the sorts of imbalances that have curtailed growth in
previous business cycles. Wages growth, for example, has remained moderate,
and there are no signs of over-investment leading to excess capacity. Business
profitability in most parts of the economy is high, and government financial
accounts suggest that fiscal policy is contributing to growth in the current
fiscal year. Against this background the Australian economy still appears well
placed to grow, notwithstanding a somewhat weaker near-term outlook. Of course,
much will depend on international developments, as Australia would be unlikely
to be unaffected in the event of a more pronounced slowdown encompassing the
US as well as other major trading partners.

Inflation in Australia remains well contained. The December quarter CPI recorded
an increase of 5.8 per cent over the latest year, a figure which incorporates
a significant contribution from the tax changes introduced in mid year and
the effects of higher petrol prices. Excluding the first-round effects of those
factors, the Bank's best estimate of core inflation over the year is around
2 per cent. This estimate is subject to some uncertainty, however, because
the size of the tax effect is not known with precision.

This result is lower than had generally been expected. Higher import prices stemming
from the lower Australian dollar have for some time been expected to begin
flowing through to the consumer, as have the indirect effects of higher fuel
prices, which have added substantially to production costs over the past year.
While these effects have been clearly evident in producers' prices and
costs, there are few signs, other than the direct increase in retail petrol
prices, of these upstream price increases being passed on to the consumer.
The lower than expected inflation outcome is open to a range of possible interpretations.
Ongoing competitive pressures, in combination with the softening in domestic
demand in the latter part of 2000, may have made it more difficult for businesses
to raise their prices and resulted in a compression of profit margins in some
areas. There is some evidence that this has been the case in the retailing
industry, although economy-wide measures of profitability have been at unusually
high levels. On the other hand, it may simply be the case that the normal lags
between movements in import prices and their pass-through to final consumers
have been lengthening, and that these effects will still become evident in
due course. It is also possible that the tax effects on consumer prices have
been smaller than estimated, which would imply a correspondingly higher estimate
of the ongoing component of inflation.

The Bank's forecast allows for some effects of the earlier fall in the exchange
rate and higher production costs to take their course. However, the experience
of a number of years now is that these pressures tend to be more muted than
was the case historically. With growth having moderated, moreover, it is likely
that domestic cost pressures will be contained. It remains the case that there
are relatively few wage rises in response to the GST, and measures of inflation
expectations have fallen, while the exchange rate has risen somewhat. Hence
there are, in the Bank's view, considerably better prospects than there
were three months ago that inflation will be comfortably within the 2–3
per cent target zone over the coming one to two years.

In summary, the risks of exceeding the inflation target have diminished since the
last Statement in November. At the same time, economic activity is growing
less quickly. While some of the most important factors at work in slowing domestic
demand should prove to be temporary, business confidence has fallen, the labour
market has softened and there is a heightened risk of a weakening in external
demand. At its February meeting, the Board concluded that the balance of risks
had shifted sufficiently that an easing of monetary policy was appropriate,
and hence cash rates were reduced by 50 basis points, to 5.75 per cent. As
with previous policy decisions, the move was intended to promote sustainable
growth of the economy consistent with the inflation target.

International Economic Developments

The world economy grew strongly in 2000, with good outcomes being recorded across
most major regions. Towards the end of the year, however, indications that
the growth cycle had peaked became increasingly apparent. The world economy
has, for some time, been expected to slow during 2001, but the extent of the
expected slowing is now somewhat greater than had appeared likely a few months
ago. The IMF recently revised down its assessment of growth prospects in 2001
by ½ a percentage point to around 3¾ per cent, largely due to
a more pessimistic outlook for the United States (Graph 1).

Graph 1

Although these forecasts still imply that global growth in 2001 will be quite good,
at around the average level recorded over the past 30 years, downside risks
to the outlook appear to predominate. Many commentators in the US, for example,
are concerned that the slowdown could be sharper and more protracted than currently
envisaged, and the continuing softening in equity markets reinforces this concern.
Globally, there are concerns about the likely flow-on effects of the slowdown
in US growth, through both real and financial channels.

Despite strong growth through 1999 and the first half of 2000, inflation remains
low. During the last year, higher oil prices have increased headline consumer
price inflation across many economies, but lower oil prices in recent months
have started to unwind this effect. Core inflation rates have picked up a little
from the rates recorded in 1999, but remain very low, and there is little evidence
of any widespread second-round effects from the earlier increase in oil prices.

United States

The much anticipated slowing in the US economy commenced in the second half of 2000.
The slowing appears to be sharper than was expected, with most private sector
forecasters revising down their outlook for 2001 over the past three months.
In response to the weaker outlook for activity, lower consumer and business
confidence and tight conditions in some segments of the financial markets,
the Federal Reserve Board lowered its target for the federal funds rate by
a total of 1 percentage point to 5.5 per cent in January.

Indications of the slowdown, which saw growth in GDP slow to an annualised rate of
less than 2 per cent, accumulated during the second half of last year (Graph 2).
Initially these were concentrated in the housing sector, but over the last
few months of the year, signs of significant slowing across the manufacturing
and retail sectors became evident and employment growth weakened. Exports grew
relatively strongly over the past year, despite the high level of the exchange
rate, although they fell a little in the December quarter.

Graph 2

The decline in growth in the latter part of 2000 was, in part, driven by a reduction
in the growth of consumer spending from the rapid pace that was recorded earlier
in the year. Consumer spending increased at an annual rate of a little over
3½ per cent in the second half of 2000, following growth of around 5½
per cent over the previous year. Weaker employment growth, and the fall in
household wealth, associated with declining share prices, may have contributed
both to the softening in consumer spending and to the sharp deterioration in
consumer sentiment that took place (Graph 3). The overall level of household
wealth, however, remains high.

Graph 3

Business conditions also weakened during the last few months of 2000. In the manufacturing
sector, there was a widespread fall in production across the traditional categories,
particularly in motor vehicle production, and growth in information technology
and communications (ITC)-related production eased a little. Total business
investment fell in the December quarter, driven by a large fall in transport
equipment, and a weakening in growth in ITC equipment spending. Non-residential
construction spending, in contrast, remained relatively robust. The weakening
in investment spending overall is not surprising, given the historically high
rates of investment in recent years. Total business investment spending as
a share of GDP remains around the peak level recorded in the early 1980s, and
well above any level recorded since. The National Association of Purchasing
Management survey implies a weak period for traditional manufacturers and non-manufacturing
firms. The outlook for the ITC sector has also weakened in recent periods,
although ITC equipment orders remain at high levels. Financial conditions facing
businesses appear to have continued to tighten. According to the Federal Reserve
Survey of senior loan officers, concerns about the credit quality of some borrowers
have resulted in tighter credit conditions being imposed on bank loans. Spreads
at the lower-quality end of the bond market have widened since mid 2000, although
they have narrowed somewhat since early January.

Overall, the slowdown in activity in the latter part of 2000 translated into slower
employment growth. In the four months to January employment growth averaged
100,000 per month – compared with the average of 150,000 per month
that was recorded in the previous six months (adjusted for the impact of census workers).
The unemployment rate edged up to 4.2 per cent in January.

After peaking in the middle of 2000, consumer price inflation declined modestly to
3.4 per cent over the year to December, primarily reflecting recent declines
in oil prices after their earlier strong increases. Core measures of inflation
remained at an annual rate of around 2½ per cent in the second half
of 2000. The outlook for core prices continues to be subdued with growth in
employment costs easing in the December quarter, slower activity likely to
ease inflationary pressures in the non-traded sector and the current level
of the exchange rate containing import prices.

Japan

The Japanese economy slowed during 2000, after having grown strongly at the beginning
of the year (Graph 4). Revisions to the national accounts suggest that
growth in the middle of 2000 was considerably lower than previously reported,
with output declining in the September quarter, driven by a large fall in public
investment. Slower export growth, combined with continued weakness in consumer
spending, also contributed to the weaker outcome. Other indicators of activity
also pointed to a moderation in growth during the second half of 2000. The
Ministry of Economy, Trade and Industry's overall business activity index
was broadly flat over the six months to November, after having increased by
around 3 per cent over the previous year, and the Bank of Japan's Tankan
survey implied that prospects for businesses deteriorated a little in the December
quarter, although they remain well above their level of a year earlier.

Graph 4

During the past couple of years, the main drivers of growth in Japan have been business
investment spending and exports. The recovery in investment spending, evident
since mid 1999, reflected an improvement in corporate profitability, particularly
in the information technology sector, and was supported by external demand
and concerted efforts towards consolidating operating costs at the firm level.
The recovery in exports reflected strong demand in the rest of east Asia and
the US. During the second half of 2000, however, external demand slowed and
growth in machinery orders weakened, particularly for ITC equipment. The longer-term
outlook for business investment thus appears to have deteriorated, although
the lower level of the yen should provide some support to exporters in the
period ahead.

The outlook for consumption remains uncertain. Little growth was recorded in consumer
spending in the June and September quarters last year, following the large
increase recorded in the March quarter, with weak growth in household incomes
continuing to constrain consumer spending. Consumer sentiment, however, continued
to improve through the second half of 2000, supported by growth of employment
of nearly 1½ per cent over the period. Consumer sentiment is now a little
above its long-run average level, and should provide support for consumer spending
in the period ahead. Consumer prices have continued to fall on a year-ended
basis, to be down by 0.2 per cent over the year to December.

Non-Japan Asia

The strong growth experienced in non-Japan Asia through the first half of 2000 continued
into the second half of the year, with GDP expanding at an annualised rate
of around 7 per cent in the September quarter
(Graph 5).[1]
Significant divergences in economic performance across the region have continued,
however, with outcomes in Thailand, Indonesia and the Philippines remaining
considerably weaker than the average. The strength in some of the economies
in the region in 2000 surprised most commentators who had expected an easing
in the rapid pace experienced since the recovery from crisis commenced. There
are, however, signs that some slowing is beginning to occur, with external
demand moderating and higher oil prices curtailing expenditure.

Graph 5

Exports continued to be one of the main contributors to growth during 2000, driven
largely by the strength in world electronics demand, particularly in the US.
The strength in electronics demand led, in turn, to a strong pick-up in investment
spending on equipment, while construction investment remained weak. Consumer
spending, in contrast, slowed during 2000 after having grown strongly over
the past two years. This may reflect, in part, the fall in share markets across
the region and related falls in consumer confidence, as well as the effect
of higher oil prices.

More recently, there have been signs that industrial production and exports in the
region are slowing, particularly in Korea and Taiwan (Graph 6). In Korea,
industrial production in December was over 8 per cent below its peak in August
and the value of exports was down 10 per cent in the December quarter. In Taiwan,
industrial production has clearly weakened since the middle of 2000, to fall
below its level of a year ago, and exports fell in the December quarter. Looking
ahead, exports from the region as a whole could be adversely affected by any
slowdown in US demand for ITC products.

Graph 6

Inflation edged up in the region in the latter half of 2000, largely due to higher
oil prices. However, inflation generally remains low, at rates around or below
those prevailing prior to the 1997 crisis, in all of these countries except
Indonesia.

New Zealand

The national accounts recorded a modest pick-up in GDP in New Zealand in the September
quarter 2000, following the decline in the June quarter. Much of the slowing
in June reflected weaker domestic demand, particularly housing and consumer
spending. Business investment, in contrast, remained quite strong through the
period. The external sector benefited from the competitive exchange rate and
strong trading partner growth over much of 2000, with very strong growth in
prices received by exporters and solid growth in export volumes in the first
half of the year. Consumer prices rose sharply for the second consecutive quarter
in December, taking headline inflation to 4 per cent, well above the RBNZ's
0–3 per cent target band. Much of the increase in the CPI in recent quarters,
however, reflected the impact of higher oil prices and increased cigarette
taxes. Excluding these factors, inflation is running at around 2.5 per cent.

Europe

The euro area expanded at a solid pace for the fifth consecutive quarter in September,
albeit at a slower rate than was recorded earlier in 2000. Despite steady employment
and wages growth, weak consumer spending was the main reason for the slowing.
In part, this may have reflected the effect of higher petrol prices and interest
charges on household cashflows. Business investment, in contrast, remained
firm, underpinned by rising capacity utilisation as a result of the recent
solid growth in industrial production and exports. While there are signs that
growth in the euro area may have softened, the overall outlook remains favourable.
Consumer sentiment continues to hold up at very high levels, and monetary conditions
and the stance of fiscal policy are also supportive of continued steady growth.
Business sentiment, however, has weakened since mid 2000, particularly in Germany.

Output in the UK increased by a modest 0.3 per cent in the December quarter, to be
2.4 per cent higher over the year. Indications are that the housing sector
has softened and business conditions remain weak, as growth in industrial production
and exports have been adversely affected by the strength of the exchange rate.
Consumption growth has been robust, reflecting firm labour market outcomes,
although there are signs that the labour market is softening, with employment
flat in the September quarter and growth in job vacancies slowing in recent
months.

International and Foreign Exchange Markets

Short-term interest rates

As evidence has emerged over the past couple of months that the US economy has slowed
more quickly than previously expected, a marked change in market sentiment
has taken place. Markets had been expecting that the monetary tightenings that
began in most countries in 1999 had further to run, but they have now swung
to expecting easings. As a result, short-term yields have fallen. This was
most pronounced in the US, though was true in other major countries also. At
the same time, the upward trend of the US dollar stalled, and bond yields also
fell.

After raising the Fed funds target by 175 basis points, to 6.5 per cent, in the 12
months to May 2000, the Federal Reserve kept rates unchanged (but assessed
that the risks were mainly toward heightened inflationary pressures) until
the last meeting of the year on 19 December. At that meeting the Fed moved
to a view that the risks were ‘weighted mainly toward conditions that
may generate economic weakness in the foreseeable future’. Markets expected
that this would mean that the Fed funds rate would be cut at the next Federal
Open Markets Committee (FOMC) meeting at end January. Yields on 90-day securities
moved down from 6.5 per cent in early December to 6.25 per cent by end December
– i.e. 25 points below the then Fed funds target.

On 3 January, the Fed surprised markets by cutting the Fed funds target by 50 basis
points to 6 per cent. This was the first inter-meeting move since October 1998,
when the Fed eased following the financial market dislocation that followed
the near collapse of a major hedge fund Long-Term Capital Management (LTCM).
It was also the first 50 basis point cut since the early 1990s recession. At
its 31 January meeting, the Fed cut policy rates by a further 50 basis points
to 5.50 per cent, and continued to maintain its easing bias. In response to
these developments, financial markets moved to price-in further easings, and
90-day yields fell to 5.25 per cent(Graph 7).

Graph 7

While the change in policy climate and sentiment has been most marked in the US,
markets are assuming that the interest rate cycle has peaked in the other industrialised
economies also. The Bank of Canada cut official interest rates by 25 basis
points to 5.5 per cent on 23 January and the Reserve Bank cut rates in Australia
by 50 basis points
to 5.75 per cent on 7 February. Other industrial country central banks have kept
official interest rates steady. The European Central Bank (ECB) last changed
rates in October 2000, when it raised rates by 25 basis points
to 4.75 per cent.
This brought the total rise over the previous 12 months to 225 points. The Bank of
England has held rates steady, at 6.00 per cent, since February 2000; and the
Reserve Bank of New Zealand has left rates unchanged at 6.5 per cent
since May 2000. Sweden was the last economy to increase official rates –
by 25 basis points to 4 per cent in December. In Japan, overnight rates were
raised in August 2000 thereby terminating the extraordinary ‘zero interest
rate policy’ of the previous two years, but the Bank of Japan has left
rates unchanged at 0.25 per cent
since (Graph 8).

Graph 8

In all major countries apart from Japan, 90-day rates are currently below official
rates, in marked contrast to the situation a few months ago (see Table 1).

Table 1: Margins between 90-day yields and cash rates

(basis points)

End Sep 2000

End Dec 2000

Current

United States

11

−25

−25

Euro area

49

7

−6

Japan

7

15

8

United Kingdom

0

−17

−29

Canada

7

−4

−23

Australia

34

−11

−12

New Zealand

14

18

−4

Sweden

20

0

−2

The decision by the Fed to ease monetary policy enabled an immediate easing of monetary
conditions in those emerging markets with exchange rates fixed to the US dollar
– Argentina, Hong Kong and Malaysia. Signs of weaker growth in a number
of other emerging markets, reflecting sluggish exports, have raised expectations
of a more widespread easing in the monetary stance among these countries. The
Philippines central bank has already lowered official interest rates in the
past two months as political developments have allowed some unwinding of its
aggressive tightening in October to underpin the peso at the time when political
instability was rising.

Long-term interest rates

The changing economic climate has seen bond yields in the US fall sharply over recent
months. Yields on US 10-year Treasury notes fell around 80 basis points between
mid October and early January, reaching a low of 4.90 per cent before the first Fed easing. This
fall was partly driven by the extreme instability in the US share market, which
increased demand for more stable and secure investments such as government
bonds. Since then, bond yields have increased modestly, to settle at around
5.20 per cent. The stabilisation of the US share market has contributed to
this.

The US yield curve has been inverted for most of 2000, with the degree of inversion
increasing to about 160 basis points
in the days before the early January rate cut, a larger degree of inversion than
that seen in the financial turmoil surrounding LTCM in 1998, and around the
same as that seen in the lead-up to the early 1990s recession. While normally
such a degree of inversion would be taken to indicate that markets are expecting
a contraction in the economy, on this occasion several factors make it harder
to interpret the implications of movements in yields. One of these is the continuing
budget surpluses in the US and the resultant reduction in supply of bonds on
issue, which may be dampening bond yields. This possible distortion is avoided
by looking at yields on AAA-rated corporate bonds. The spread between these
bonds and the cash rate also inverted in late December, though less markedly
than that for Treasuries and also by less than in the lead-up to the early
1990s recession. This measure, however, is also affected by special factors
at present – namely rising credit spreads on all private debt in the
US. Nevertheless, it does suggest that markets do expect significant economic
weakness ahead.

The spreads on corporate bonds in the US have increased significantly over recent
months, suggesting an increase in concerns about credit quality in US markets.
Spreads across the entire credit spectrum have risen, exceeding the highs seen
in 1998 (Graph 9). Spreads on high quality AAA-rated paper relative to
Treasury securities increased from around 80 basis points to 125 basis points
over 2000. Spreads on the lower-quality bonds rose by more, with the ‘junk’
bond sector suffering the largest rise. Spreads on these latter securities
moved to about 700 basis points over Treasury securities of comparable maturity,
up over 300 basis points during the year. Since the Fed cut interest rates
in early January, credit spreads have narrowed somewhat, suggesting that markets
anticipate that the easing of monetary policy will contain the increase in
corporate risk.

Graph 9

In European markets, yields on long-term government bonds have fallen in recent months,
though less so than in the US. After trading in a relatively narrow range around
5.2 per cent for several months, the 10-year German yield moved down from mid
November, falling by around 50 basis points by early January. Since then yields
have risen by over 10 basis points to trade around 4.8 per cent. The spread
between US and German 10-year government bonds narrowed by about 20 basis points,
to around 40 basis points, over December and January. Japanese long bond yields
increased modestly after the Bank of Japan ended the ‘zero interest rate
policy’ in August 2000, reaching highs around 2.00 per cent,
before falling back to their current level of about
1.50 per cent as weaker economic data accumulated
in the latter part of the year (Graph 10).

Graph 10

In emerging markets, bond yields rose through to December as markets became increasingly
risk averse, both because of general concerns about the impact on emerging
markets of the slowdown in the US and specific problems in several countries,
particularly in Argentina and Turkey. The spread to US bond yields widened
to almost 800 basis points, from a low of around 630 basis points earlier in
the year. However, as with the US corporate market, the general risks surrounding
emerging markets were seen to narrow somewhat as the Fed began to cut official
interest rates in the US. This saw spreads fall back below 700 points by the
end of January (Graph 11).

Graph 11

Equity markets

The prospect of significantly weaker economic growth and a string of disappointing
earnings announcements, particularly by technology companies, have weighed
on equity markets. US markets have led the fall over recent months. The Wilshire
index, the broadest measure of US share prices (accounting for over 90 per
cent of listed companies) fell by 14 per cent in the three months to early
January. While the S&P 500 experienced similar falls, the Dow Jones index
(which covers largely ‘blue chip’ stocks) was flat over this period
as investors moved back toward lower risk investments. At the same time the
technology rich NASDAQ fell around 35 per cent (Graph 12). All the major
US stock indices saw large falls in 2000, the first year of negative returns
for the broad-based indices since 1994. However, since the Fed began easing
monetary policy, US equity markets have recovered modestly, with the Wilshire
up 5 per cent, the Dow up 3 per cent and the NASDAQ up 14 per cent.

Graph 12

Share prices in most other countries have followed the US markets down over 2000.
Depending on the composition of share price indices in the different countries,
some peaked early in 2000, around the time of the peak in technology shares,
while others experienced a later peak (Table 2). Broad–based indices
in most countries were down by around 10 per cent over 2000. Only in two countries
– Canada and Australia – did share prices show a net rise over
the year.

Table 2: Changes in Major Country Share Prices

Change over 2000

Change since peak

Change since 3 Jan 2001

United States

– Wilshire

−12

−16

5

– Dow Jones

−6

−7

3

– S&P 500

−10

−12

5

– NASDAQ

−39

−48

14

Germany

– DAX

−8

−18

5

United Kingdom

– FTSE

−10

−10

3

Japan

– Nikkei

−27

−36

−2

Australia

– ASX200

3

−2

3

Canada

– TSE 300

6

−20

6

Among the major countries, the biggest fall in share prices in 2000 was in Japan.
Share prices in that country fell sharply in the first half of 2000 as the
Japanese index was heavily affected by the collapse of technology stocks. More
recently, pessimism regarding the outlook for the Japanese economy led to a
further substantial slide in share prices, with the Nikkei falling to levels
not seen since the Asian crisis.

As Japanese equity prices fell, the market began to focus on the potential impact
on the solvency of the Japanese banking sector and, given the banks' role
in funding the corporate sector, on the economy more generally. However, despite
continuing problems with the banks' balance sheets, price-based market
assessments of the banking industry do not appear to have deteriorated significantly
over the past year. The market value of bank shares has not under-performed
the market average, as was the case in the lead-up to the banking problems
of 1998 (Graph 13). In addition, the ‘Japan premium’ (the
additional margin which Japanese banks must pay to borrow short-term funds
on world markets) remains negligible, compared with a peak of around 80 basis points at the time of the banking crisis
in 1998. The recapitalisation package announced in October 1998 helped reduce
this premium.

Graph 13

Equity prices in the Asian-crisis economies – Indonesia, Korea, Malaysia, Philippines
and Thailand – experienced average falls in the order of 40 per cent
in 2000, to levels only marginally above those reached during the 1997–98
financial crisis (Graph 14). The slump was largely due to an assessment
by markets that these economies were vulnerable to slowing world growth, and
in particular to a downturn in the global electronics cycle. However, since
the first easing by the US Fed, share prices in the region have recovered modestly,
rising by 10 per cent in the year to date. Latin American share prices also
registered a recent upturn, following weakness in 2000.

Graph 14

Exchange rates

The past few months have seen a fundamental change in the momentum underpinning movements
in the three major global currencies. After strengthening significantly on
a trade-weighted basis over recent years, the US dollar peaked in mid November
as evidence emerged that the US economy was slowing significantly. Between
mid November and the start of January, the trade-weighted US dollar fell by
5 per cent, after increasing 13 per cent up until that point in 2000 (Graph 15).
The Fed's surprise easing in early January prompted a further move downward
in the dollar. However, as markets have come to see this as an indicator of
the Fed's determination to prevent a prolonged slowdown in the US economy
and some of the gloom surrounding the economic outlook dissipated, the US dollar
stabilised and has since moved modestly higher against the major currencies
(other than the yen).

Graph 15

The peak of the US trade-weighted index broadly coincided with the trough in the
Euro/US dollar bilateral exchange rate. From its introduction at the beginning
of 1999, the euro fell by close to 30 per cent to an historic low of US82.3
cents in October 2000. Concerted intervention by the G7 central banks in September,
and subsequent bilateral intervention by the European Central Bank, helped
to stabilise the euro, which then strengthened by over 15 per cent to reach
a peak of US95.8 cents in early January, immediately after the US Fed's
surprise easing. More recently the Euro has fallen again against the US dollar
as the bearishness regarding the US dollar has eased (Graph 16).

Graph 16

Despite the slowdown in the US economy, the yen has weakened against the US dollar
in recent months. After trading in a 105 to 110 range between January and November
2000, the yen fell to almost 120 against the US dollar by mid January. It has
since generally remained in a range of 115 to 120.

Elsewhere in Asia, the currencies of countries with floating exchange rates appear
to have stabilised against the US dollar after falling through most of 2000
(Graph 17). This has gone hand-in-hand with a modest recovery in domestic
share markets in the region. Most floating Latin American currencies also depreciated
against the US dollar over the course of 2000, but there too the trend may
have been arrested recently. The Brazilian real has been stable in recent months,
and the Mexican and Chilean pesos have appreciated marginally against the US
dollar.

Graph 17

Australian dollar

Movements in the Australian dollar have to a large degree continued to reflect fluctuations
in investor sentiment towards the US dollar. The strong demand for US dollars
that characterised most of 2000 eventually moderated late in the year with
the run of weak economic data in the US and, shortly after, the surprise monetary
policy announcement. The resulting fall in the US dollar on world markets saw
the Australian dollar rise quite sharply against it between late November and
early January, as did all other major currencies apart from the yen.

The winding-back of expectations of the growth of US economic activity was evident
throughout the December quarter but particularly late in the quarter. The US
dollar stopped rising in trade-weighted terms in November and the Australian
dollar stabilised at around US52 cents. This emerging tendency towards stability
was assisted by several rounds of quite sizeable intervention by the Reserve
Bank to support the exchange rate. Though the Australian dollar briefly fell
to a low of US50.7 cents in late November, it recovered sharply to above US55
cents in December as growth estimates for the US continued to be wound back
much more quickly than those for Australia (Graph 18).

Graph 18

The announcement of a 50 basis point cut by the Fed in early January surprised most
observers, and tended to weaken the US dollar immediately after the announcement.
At that time, the Australian dollar climbed briefly above US57 cents, more
than 10 per cent above its November low. Thereafter, as US asset markets settled,
sentiment about the US dollar improved. At the same time, the consensus growth
outlook for Australia was also reduced more sharply. The Australian dollar
declined to around US54–55 cents (Graph 19). Markets had already
fully priced-in the 50 basis point easing in Australia in early February and
its announcement had little impact on the exchange rate.

Graph 19

With the US dollar remaining the major focus of markets in recent months, most other
major currencies (except the yen) have shown similar movements against it (Graph 20).
This has meant that correlations between the Australian dollar and these other
currencies, particularly the euro, have been much higher than usual. Correlations
of daily movements between the euro and the Australian dollar have increased
to around 0.75 from 0.25 early last year and an average of close to zero during
the 1990s (Graph 21). The most recent observations are comparable with
the correlation between the Australian dollar and the US dollar when the local
currency was regarded as being one of the ‘US dollar bloc’ currencies.
That strong relationship, which had been prevalent throughout most of the floating
period, broke down around 1997 when markets brought about a significant depreciation
of the local currency in reaction to the onset of the Asian crisis.

Graph 20

Graph 21

Even though the Australian dollar has been quite steady against many other currencies,
the trade-weighted index rose noticeably in the closing weeks of last year
and early this year. This reflected in part the importance of the US dollar
in the TWI, but also the fact that the yen weakened at the same time; together,
these two currencies (and currencies tied or managed to the US dollar)
make up about half the trade weights.

With the recovery of the Australian dollar from its lows in November, the Bank has
remained out of the market, except for a few occasions in December and January
when market liquidity was seasonally low and the Bank intervened on a small
scale to ensure that the exchange rate did not behave erratically in the thin
conditions.

Domestic Economic Activity

Growth in the Australian economy slowed in the second half of the year, after a very
strong first half. The extent of the slowdown is difficult to gauge as most
indicators of the pace of activity have been influenced by the introduction
of the new tax system and, to a lesser extent, by the staging of the Olympic
Games. At the same time, the composition of growth has continued to shift,
with stronger growth in exports providing some offset to the weaker growth
in domestic demand (Graph 22, Table 3).

Graph 22

Table 3: National Accounts

Percentage change, seasonally adjusted

Six months to: (annualised rate)

September quarter 2000

March quarter 2000

September quarter 2000

Private Final Demand(a)

5.1

−0.9

−1.5

Consumption

4.6

3.2

0.7

Dwelling Investment

21.6

−29.2

−21.5

Business Investment(a)

−0.9

−2.0

−0.2

Public Final Demand(a)

10.5

0.8

2.2

Change in Inventories(b)

−1.7

1.3

0.6

Exports

11.7

13.2

3.8

Imports

10.6

0.6

0.4

Net Exports(b)

−0.2

2.4

0.7

Gross Domestic Product

5.0

3.4

0.6

(a) Excluding transfers between the public and private sectors (b)
Contribution to GDP growth

The increase in real GDP of 0.6 per cent in the September quarter recorded in the
national accounts was less than that in recent quarters, but was particularly
affected by the changes to the tax system and the Olympic Games. The net effect
of the GST was to transfer activity from the second half of the year into the
first half. This was most prevalent in the housing sector where the fall in
dwelling investment in the September quarter subtracted around 1¼ percentage
points from growth. The new tax arrangements also affected the timing of some
consumption spending, most notably motor vehicle purchases, and business investment
spending.

In contrast to the effects of the tax system, the Olympics provided a net boost to
GDP in the September quarter. The direct effect in the form of higher exports
(broadcast rights and ticket sales to non-residents) and consumption (ticket
sales to residents) is estimated to have been just under ¾ of a per
cent of GDP, but this will have been offset to some extent by the diversion
of spending from other forms of consumption and the disruption to business
activity during the staging of the Games. The most recent indicators suggest
that the slower overall pace of growth continued in the last few months of
the year.

Household consumption

Consumer spending grew at a more moderate pace over the past year. Household consumption
increased at an annualised rate of 2 ¾ per cent in the September quarter,
compared with growth of around 5 per cent per annum in recent years. While
retail trade increased strongly in the December quarter, there is no doubt
that the strong consumption growth of recent years has slowed.

A number of factors have contributed to reduce the growth of consumption, including
the rise in the interest burden of households due to increases in household
debt and the tightening of monetary policy since November 1999,
and a slowdown in the accumulation of household wealth. Higher petrol prices are
also likely to have led households to reduce spending on other goods and services,
along with the requirement for some households to pay the second instalment
on their purchases of shares in the Telstra 2 float by early November. These
contractionary influences have been partly offset by continued strong growth
in household borrowing and the boost to household income from the tax cuts
and benefit increases associated with the new tax system.

Consumption growth as recorded in the September quarter was boosted by domestic sales
of Olympic tickets and domestic tourism expenditures as residents of other
states travelled to watch the Games. However, the tendency for households to
spend more time at home or involved in Olympics-related activities is likely
to have reduced expenditure in other areas over this period.

There was also a marked shift in consumption patterns between the June and September
quarters as a result of the relative price changes associated with the introduction
of the new tax system. The largest shift in expenditure was on motor vehicles,
which was around 40 per cent higher in the September quarter than in the June
quarter, reflecting the lower taxes and hence prices after 1 July. Motor vehicle
sales have remained at a high level in recent months, though somewhat below
the initial spike when the tax changes were introduced (Graph 23).
These price effects were amplified by manufacturers' decisions to delay the launch
of a number of new models onto the Australian market until after 1 July. Other
areas of expenditure such as clothing and footwear and household furnishings
declined following the tax changes as consumers had brought forward their expenditure
to earlier quarters in anticipation of higher prices after 1 July.

Graph 23

The pace of retail spending, which accounts for around one-third of total consumer
spending, also slowed in 2000. Retail spending has been particularly volatile
over the course of the year because of the changes in the tax system. It fell
by 3.3 per cent in real terms in the September quarter, but rose by 1.8 per
cent in the December quarter so that its level in the second half of 2000 was
lower than in the first half. The slowdown has been most noticeable in spending
on clothing, recreational goods and hospitality and services.

In line with the slowdown in consumption growth, consumer sentiment has fallen from
the high levels of 1999. It has varied considerably over the past year, reflecting
uncertainty about the impact of the tax changes, financial market volatility
and higher interest rates and petrol prices. Nevertheless, in recent months
consumer sentiment appears to have stabilised at a level slightly above its
long-run average, which would be consistent with continued moderate growth
in consumption.

Household disposable income grew by around 4 per cent in the September quarter, boosted
by the increase in social assistance benefits and decrease in income taxes
associated with the changes to the tax system. The sharp increase in disposable
income combined with the slowdown in growth in consumption expenditure resulted
in an increase in the household saving ratio to 4 per cent of disposable income
in the quarter, up from 2.7 per cent a year ago.

Growth in household borrowing has moderated from the very fast pace of the first
half of last year, mainly reflecting a deceleration in lending for housing,
and particularly lending for investment property. Personal credit growth has
also eased a little in recent months though it remains strong, especially in
the form of credit card and overdraft lending. Total credit to the household
sector increased at an annual rate of around 11½ per cent over the six
months to December, down from a rate of nearly 18 per cent in June, a figure
which had been boosted by the pre-GST surge in housing activity.

While the overall rate of growth of household borrowing has declined in recent months,
it continues to exceed the growth of incomes, and hence the ratio of household
debt to disposable income has increased further. This continues a trend that
has been evident in Australia for more than a decade. In large part, the trend
increase in the debt-to-income ratio represents a long-term structural change
– households have been adjusting to a deregulated financial system in
which credit has become more freely available and, with lower interest rates,
is more affordable. In the course of this process, the Australian household
sector has moved from having a relatively low level of debt by international
standards to a position where the debt ratio is comparable to that in other
countries (Graph 24). (If unincorporated enterprises were included, the
debt ratio in Australia at present would be around 10 percentage points higher
than is shown in the graph.)

Graph 24

While it is difficult to establish what would be a sustainable debt ratio for the
household sector in the longer term, the rapid increase does pose the risk
of some households becoming overstretched, particularly if the level of borrowing
were to continue growing at the rates seen in the past couple of years. One
measure of the capacity of households to service their debt is the ratio of
interest payments to disposable income. The combination of increased household
indebtedness and higher interest rates in the past year has seen this ratio
continue to increase, to a level higher than the most recent peak reached in
the mid 1990s, but still well below the late 1980s peak (Graph 25).

Graph 25

After increasing at a relatively rapid pace for much of the past four years, growth
in the value of household assets has slowed considerably in recent quarters.
The pattern is difficult to gauge because measures of the value of houses,
which account for the bulk of household assets, have been distorted by compositional
changes in the mix of house buyers related to the introduction of the new tax
system. The availability of the Federal Government's First Home Owner Grant
after 1 July (and a concession on stamp duty in NSW) encouraged first-home
buyers to delay their house purchases until the September quarter. As first-home
buyers are likely to buy cheaper dwellings on average, this boosted the average
purchase price in the June quarter and depressed it in the September quarter.
The CBA/HIA measure of established house prices, which is likely to be most
affected by this change, fell by 10.5 per cent in the September quarter, after
rising by 5.2 per cent in the June quarter (Graph 26). The REIA and ABS
measures of house prices, which are less affected, fell by 3.8 per cent and
0.1 per cent, respectively, in the September quarter.

Graph 26

Growth in household financial assets has also slowed in recent quarters (Table 4),
primarily reflecting slower growth in the value of both direct and indirect
equity holdings. Nevertheless, the value of household direct equity holdings
has continued to rise, in contrast to the US where the value of household direct
equity holdings fell by around 13 per cent in the six months to the September
quarter.

Table 4: Household Financial Assets

Level
$b

Share of financial assets
(per cent)

Annualised growth (per cent) Six months to:

Mar quarter 2000

Sep quarter 2000

Currency and deposits

257

21.8

3.4

8.8

Direct equity holdings

240

20.3

33.3

7.6

Superannuation and life offices

618

52.4

19.2

6.7

– Equities

307

26.1

41.0

15.8

Other

64

5.5

0.5

−11.1

Total financial assets

1,179

100.0

16.8

6.2

Dwelling investment

Following record growth over the year to June 2000, residential construction activity
declined sharply in the second half of the year. According to the national
accounts, private dwelling investment fell by more than 20 per cent in the September quarter, to be around
7 per cent lower than a year earlier, with sharp falls in both the construction
of new dwellings and alterations and additions. As a share of GDP, dwelling
investment fell from around 6½ per cent to 5½ per cent –
although this returned it only to the same level as at the two previous
cyclical peaks (Graph 27). Forward indicators point to a further,
though much smaller, decline in activity in the December quarter.

Graph 27

The shape of this housing cycle has been significantly affected by the introduction
of the GST, which created the incentive for dwelling construction to be undertaken
before 1 July. Combined with the effects of the rise in interest rates, this
led to the very sharp decline in activity in the housing sector in the second
half of 2000. In contrast to previous dwelling cycles, at this stage there
is little evidence of a large oversupply of dwellings, which suggests that
the downturn may not be as protracted as in the past. In addition, the prospects
for a recovery in the dwelling sector have been bolstered by an increase in
affordability in recent months as growth in house prices appears to have eased
and as fixed home loan rates have declined.

Dwelling activity is likely to fall further in the December quarter and leading indicators
suggest that the lower level of activity is likely to persist into the first
part of 2001. However, a number of forward indicators appear to have reached
bottom and suggest some pick-up in activity is in prospect later in 2001. The
number of private new dwellings approved has increased in the last quarter
of 2000, to be 12 per cent above the trough reached in September, although
they remain 36 per cent lower than a year earlier (Graph 28). The increase
in approvals has been evenly spread across houses and medium-density units.
The number and value of loan approvals rose strongly in November, recovering
from the low levels recorded in September and October. Much of the strength
was in lending to investors although loans to owner-occupiers also picked up.
The downturn in the housing sector has been broadly similar in magnitude across
the states, and most states have shown signs of a recovery in recent months.

Graph 28

The business sector

Reflecting the varying economic conditions, business surveys have reported marked
differences in business sentiment across industries. The ACCI-Westpac survey
of manufacturing firms reported a decline in expected business conditions over
the next six months. The Dun and Bradstreet survey, which focuses on the manufacturing,
wholesale and retail trade sectors, also reported a decline in the period ahead.
In contrast, the more broadly based ABS Survey of Business Expectations and
NAB quarterly survey reported an expectation of a significant improvement in
business conditions over the coming year in the mining sector, and a continuation
of buoyant conditions in the property and business services sector, but a worsening
in conditions in most other sectors. The NAB survey also indicated that exporters
were enjoying good conditions.

In addition to the variation across industries, there have also been major differences
in sentiment between smaller and larger businesses. According to the ABS Survey
of Business Expectations, large firms have a positive outlook for sales and
profit growth over the coming year whereas small firms are reporting a sharp
deterioration in sales and profit growth.

Notwithstanding this variation across sectors, the business surveys consistently
suggest a deterioration in business sentiment for the economy as a whole in
the second half of 2000. The survey responses are, however, less definitive
on the exact causes of this change. In general, businesses report, as they
almost always do, that the factor most constraining production or profitability
is demand or orders, with an array of other factors playing a minor role (Table 5).
There have been only minor changes to this pattern of late, and hence it is
necessary to look beyond the survey responses in forming an assessment of the
reasons behind the decline in confidence.

Table 5: Factors Influencing Business Sentiment

Percentage of firms nominating each factor

NAB Survey(a)

ACCI-Westpac Survey(b)

Demand

47

Orders

71

Wage costs

9

Capacity

5

Exchange rate too low

9

Labour

3

Recent tax changes

7

Finance

1

Interest rates

5

Material

0

Exchange rate too high

5

Availability of suitable labour

5

Inadequate capital capacity

4

Other

8

(a) Respondents were asked in December 2000 to nominate the factor most
constraining profitability over the next 12 months. (b) Respondents
were asked in November 2000 to nominate the major factor limiting production.

On this occasion, the extremely sharp downturn in housing activity in the second
half of 2000 has reduced demand and employment, not only in the housing industry
itself but in those parts of manufacturing that supply the housing sector.
Also, higher petrol prices have reduced the amount of income that consumers
have available to purchase other goods and services. Similarly, higher import
prices have contributed to a squeeze on margins in some parts of manufacturing,
wholesaling and retailing, although in other parts of the economy such as those
that export or compete against imports, profit opportunities have expanded.
According to the Yellow Pages survey, small businesses also had some difficulty
in changing accounting and record-keeping systems to comply with the new tax
system. The rise in interest rates earlier in the year would also have contributed
to some reduction in business confidence, particularly during the period when
further increases were expected. Finally, over the most recent few months,
the gloomier news from the United States, particularly concerning its share
markets, would have influenced business confidence in Australia.

The transition to the new tax system has meant that companies will be paying tax
on income earned in the current year at the same time that they are paying
tax on income earned in 1999/00. Transitional arrangements have been implemented
to alleviate this problem by allowing some payments to be deferred (see Box A), and hence this should not have a major effect
on business cash flow provided businesses take full advantage of the deferral
arrangements. In its Mid-Year Economic and Fiscal Outlook (MYEFO), the Government
reported that there appeared to be a short lag between when businesses report
GST receipts on sales and when they claim input tax credits relating to those
sales, and also that there was a lag in the processing of net refunds by the
Australian Tax Office.

Aggregate measures suggest that, on average, the financial position of the corporate
sector has remained strong. Corporate GOS rose by over 17 per cent over the
year to September and was at an historical high as a share of GDP (Graph 29).
Profit growth in the mining sector has been particularly strong over the past year,
whereas profit levels in the retail and wholesale sectors appear to have fallen.
There is some evidence that conditions for small business are less favourable,
with profits of unincorporated enterprises falling by 1.2 per cent in the September
quarter, although they are nearly 6½ per cent higher over the year.

Graph 29

The business surveys reported lower profitability in the December quarter, although
again there was variation across sectors and between small and large businesses
(Graph 30). The broadest measure shown by the NAB survey indicated that
profitability had fallen to about the same level as in 1996. The Dun and Bradstreet
survey and the ACCI survey of manufacturing showed a similar result. On the
other hand, the survey of manufacturing carried out by the Australian Industry
Group and the Yellow Pages survey of small business, showed profitability at
a lower level than in the mid 1990s.

Graph 30

Aggregate business investment has been flat for a number of quarters, although this
masks contrasting developments in the components of investment. Investment
in new machinery and equipment increased by nearly 5 per cent in the September
quarter (Graph 31) and by 8 per cent over the past year. Some part of
the increase in the September quarter may have reflected the deferral of purchases
to take advantage of the fall in the price of some investment goods with the
abolition of wholesale sales tax. The outlook for investment in machinery and
equipment for 2000/01, as measured in the latest ABS Capital Expenditure Survey
appears quite positive. Firms upgraded their machinery and equipment investment
plans significantly, implying around 6 per cent growth in nominal terms over
2000/01. Much of the expected growth is in the communications, property and
business services and mining sectors, where recently business sentiment has
been more buoyant.

Graph 31

New investment in buildings and structures continued to decline from the peak reached
almost two years ago, falling by a further 15 per cent in the September quarter.
Expenditure on engineering construction has been particularly weak and is around
one-third lower than a year earlier. Much of this decline has been due to weakness
in resource-related projects, although in the September quarter, work done
on infrastructure projects also declined. While committed projects in the quarter,
as reported in the Access Investment Monitor, rose to their highest level since
the early 1990s, many of the major projects are still in the planning stage
and are likely to have little impact on work done until well into 2001/02.
However, non-residential building approvals point to an increase in office
construction, underpinned by the gradual tightening in CBD office space availability
and the consequent strong growth in office rents.

The other major component of business investment, expenditure on intangible fixed
assets, rose moderately in the September quarter to be nearly 8 per cent higher
than a year ago. Increases in expenditure on computer software (around 80 per
cent of the total) and minerals and petroleum exploration contributed to the
growth in the quarter. The increase in exploration expenditure, together with
strong profitability, points to the possibility of a rebound in capital expenditure
in the mining sector, which has been subdued for a number of quarters.

The availability of funds is not likely to be a constraint on business investment.
As discussed above, profit levels are high, even if down a little from their
September quarter peak. Net equity raisings have also been high with gross
raisings remaining buoyant and buy-back activity easing. At the same time,
businesses have not been using debt financing as much recently, possibly reflecting
higher interest rates charged by intermediaries and the slowdown in economic
activity. Business credit growth has slowed to an annualised rate of around
5 per cent over the six months to December from 13 per cent over the six months to June. In the
December quarter, the slowing in intermediated business borrowing was offset
to a small degree by increased debt raising through capital markets (see the
chapter on ‘Domestic Financial Markets’).

Measures of the corporate interest burden remain low by historical standards, reflecting
a combination of high profitability and relatively low levels of interest rates
and corporate indebtedness (Graph 32). Debt-to-equity ratios have been
broadly flat over the past few years, and remain well below levels of a decade
ago.

Graph 32

Commonwealth Budget

In November the Commonwealth Government reassessed its budget forecasts in its Mid-Year
Economic and Fiscal Outlook (MYEFO). The expected underlying cash surpluses
for 2000/01 and for 2001/02 were both revised up by about $1½ billion,
while the estimate of the actual surplus in the previous year was revised upwards
by a larger amount. The revision to the estimate for the current year in part
reflected upward revisions to forecasts of GDP and employment growth, and ongoing
base effects of stronger-than-expected tax receipts in 1999/2000.
Higher Pay-As-You-Go withholding tax receipts, company tax receipts and the
petroleum resource rent tax contributed the most to the upward revision to
revenue in 2000/01.
The upward revision to expected revenue was partially offset by higher expenditures.

While the estimated level of the surplus for both the current and the previous year
has been revised upwards, the revised estimates suggest that the Commonwealth
Budget position remains expansionary in its impact on growth in the economy
in the current fiscal year. Using the change in the surplus between years as
a rough indicator of the impact on growth, the revised estimates indicate that
the surplus in 2000/01 will be 1.4 per cent of GDP lower than in the previous
year. This compares with an estimated reduction of 0.8 per cent of GDP at budget
time (Table 6). Subsequent to the latest estimates, the Government has
announced spending packages on roads and innovation worth $1.6 billion and
nearly $3 billion respectively over the next five years, with most of the impact
occurring in the later years of that period.

Table 6: Commonwealth General Government Underlying Cash Surplus

$ million, per cent of GDP

1998/99

1999/00

2000/01

2001/02

Budget

41,90

7,795

2,844

3,211

(0.7)

(1.2)

(0.4)

(0.5)

MYEFO

4,190

12,671

4,329

4,738

(0.7)

(2.0)

(0.6)

(0.7)

The labour market

Conditions in the labour market have softened in recent months, with employment growth
slowing from the rapid pace experienced around the middle of the year and the
unemployment rate edging up after having fallen to its lowest level in a decade
in the September quarter (Graph 33). After rising by 3.5 per cent over
the year to the September quarter 2000, employment fell by 0.5 per cent in
the December quarter, but remained 2.2 per cent higher than a year earlier.
The unemployment rate rose slightly in the December quarter to 6½ per
cent, around ½ of a percentage point lower than in the December quarter
1999. Employment fell slightly in January, and the unemployment rate increased
to 6.7 per cent. The participation rate has declined from its recent peak but
remains a little higher than a year earlier.

Graph 33

The composition of employment has been affected by the conjunction of the introduction
of the new tax system and the Olympic Games. In particular, the strong growth
in construction employment over the past couple of years was partly reversed
in the second half of the year as activity in that sector declined from its
pre-GST peak. Employment has also fallen over the past year in the wholesale
trade and manufacturing sectors, whereas it has risen strongly in the service
sector, particularly in hospitality and property and business services.

Over the year to the December quarter, most states experienced solid employment growth
and declining unemployment rates (Table 7), with particularly rapid employment
growth being recorded in Victoria. In the latter part of the year, employment
growth slowed in all states except Western Australia and Tasmania. Employment
growth over the past year has been stronger in regions outside the capital
cities. Consequently, unemployment rates in these areas have generally fallen
more rapidly over the past year, but still typically remain higher than in
the capital cities.

Table 7: Labour Market Conditions by State

Per cent

NSW

Vic

Qld

SA

WA

Tas

Australia

Employment growth

– Year to Dec quarter 2000

2.0

3.6

1.8

0.5

1.2

2.2

2.2

Unemployment rate

– Dec quarter 1999

6.0

6.9

8.2

8.2

6.6

9.4

7.0

– Dec quarter 2000

5.8

6.1

7.9

7.4

6.2

8.9

6.5

Most forward-looking indicators of labour demand suggest that employment growth will
remain subdued over the next six months or so. The number of jobs advertised
in newspapers has fallen to be around 20 per cent lower than its peak in May
2000, although recently there have been some signs of recovery. The ANZ Bank
series increased by 3.7 per cent from November to January, while the index
of skilled job advertisements compiled by the Department of Employment, Workplace
Relations and Small Business (DEWRSB) recorded a large increase over the same
period. The decline since the peak last May has been exacerbated by the trend
towards advertising for information-technology professionals on the internet,
but the number of advertisements for tradespersons – and for construction
workers in particular – has fallen sharply, in line with the decline
in construction activity.

The major surveys of business expectations also point to a softer outlook for the
labour market (Graph 34). The NAB quarterly survey reported that employment
intentions for the March quarter have declined to quite low levels, and the
ACCI-Westpac survey indicates that hiring conditions are weak in the manufacturing
sector.

Graph 34

In contrast to the other labour market indicators, the ABS measure of job vacancies
has remained much more buoyant. Based on a survey of employers rather than
a count of newspaper advertisements, the ABS measure indicates that the number
of job vacancies has risen in each of the past seven quarters and in the December
quarter, was 14.6 per cent higher than a year earlier. The ABS series has been
boosted by strong growth of job vacancies in the property and business services
sector, which includes vacancies for IT workers likely to have been missed
by counts of newspaper job advertising; in addition, the series has not been
as severely affected by the recent contraction in the construction industry.

Box A: Changes in the Timing of Company Tax Payments

Since 1 July 2000, the lag between when a company earns income and when it pays tax
on that income has been substantially reduced. Under the new tax system, companies
will pay most of their company tax instalments in the financial year in which
the liability is incurred. This contrasts with the previous system in which
companies (unlike individuals) paid much of their tax after the year in which
income was earned. The switch to the new system raises the possibility of
larger tax payments this financial year as companies pay tax both on income
earned in 1999/2000 (under the old tax arrangements) and income earned in
2000/01 (under the new tax arrangements). However,
deferral arrangements reduce this burden markedly in 2000/01 by allowing payments
to be spread over a number of years. The deferral arrangements vary according
to the amount of tax paid by a
company.[1]

Large tax companies

Under the old tax arrangements, large tax companies (those that pay more than $300,000
annually) paid tax in four quarterly instalments: the first two instalments
fell due in March and June of the relevant fiscal year, with the remaining
instalments in September and December of the next fiscal year (Graph A1, top panel). Under the new arrangements,
companies pay corporate tax mainly in the year in which it is accrued: tax
is based on quarterly income and is paid three weeks after the end of the
quarter (Graph A1, middle panel).

Graph A1

In the absence of the deferral arrangements, a large company would have had to pay
about 125 per cent of its normal annual tax bill in 2000/01 – 50 per
cent (two instalments) of its annual tax bill for 1999/2000 profits, as well
as 75 per cent of the tax bill incurred in 2000/01. Under the deferral arrangements,
companies can defer most of the fourth instalment on 1999/2000 profits and
pay it in equal quarterly instalments over the next 2½ years. A company
making full use of the deferral provisions might expect to pay about an extra
10 per cent of its normal tax bill in 2000/01.

Medium tax companies

Previously, medium tax companies (companies that pay between $8,000 and $300,000
tax per year) paid the first quarterly tax instalment in the June quarter
of the relevant fiscal year (a quarter later than large companies), with the
subsequent three quarterly instalments paid in the following financial year
(Graph A2, top panel). The new arrangements bring
this tax payment schedule forward by about seven months. However, the deferral
arrangements allow companies to defer the third instalment on 1999/2000
profits and most of the fourth instalment, with these payments to be made over the
next five years. As a result, the total tax bill for a medium-sized company
in 2000/01 will be around 10 per cent
more than in a normal year.

Graph A2

Small tax companies

Small tax companies (companies that pay less than $8,000 per year) represent over
80 per cent of the number of corporate taxpayers, although they account for
only 3 per cent of corporate tax collected. Under the old arrangements, these
companies made one annual tax payment in December in the fiscal year following
that in which profits were earned (Graph A3, top panel). The new arrangements
require quarterly tax payments for small tax companies that are registered
for the GST. (Small tax companies that are not registered for the GST can
continue to make annual payments.) Without the deferral arrangements, small
companies would have been required to pay, during the 2000/01 fiscal year,
all of the tax on profit earned in 1999/2000,
plus three quarterly instalments based on 2000/01 profits. Small tax companies have
been permitted to defer all of the tax on profit earned in 1999/2000 which
was due in December 2000, and pay it in quarterly instalments over five years
from April 2001. A company which fully used the deferral provisions would
pay around 20 per cent less tax in 2000/01 than in a normal year.

Graph A3

Balance of Payments

Strong trading partner growth, the lower Australian dollar and the Olympics all continued
to support Australia's external accounts during the second half of 2000.
From the recent peak of nearly 3 per cent of GDP, reached in September 1999,
the quarterly trade deficit narrowed to around ½ of one per cent of
GDP in the December quarter 2000. The staging of the Olympics and the Paralympics
obviously contributed to this outcome, and according to the ABS, boosted exports
by around 0.9 per cent of GDP in the September quarter and 0.1 per cent of GDP in the December quarter. After
abstracting from these events, however, it is still clear that the trade balance
has narrowed considerably, driven by continued strong growth in exports and
some moderation in imports (Graph 35).

Graph 35

The value of exports increased by over 4 per cent in the December quarter and was
27 per cent higher than a year earlier (abstracting from the effect of the
sale of a frigate in the December quarter 1999). The lower exchange rate ensured
that prices in Australian dollar terms contributed to the quarterly rise. Export
growth has been strong to all major destinations over the past year, with particularly
strong growth to east Asia and Japan
(Graph 36). Much of the increase in the value
of exports to east Asia and Japan has been in resources, although service exports
to this region also rose considerably in the December quarter, following weakness
in the peak Olympic period.

Graph 36

Resources exports have been the fastest growing export category over the past year,
and this continued into the December quarter. Over the year to December, resource
export earnings increased by 45 per cent, excluding re-exported gold. Although
higher prices have contributed to some of this increase, the quantities of
mineral fuels, metals and other non-rural goods exported have also risen strongly,
in several cases as a result of new production coming on stream. The increase
in mineral fuel exports has been most pronounced for crude oil, where quantities
exported have risen by over 50 per cent over the last year and have nearly
doubled over the last two years.

Earnings for rural exports rose modestly in the December quarter, driven by higher
prices. The value of greasy wool and meat exports both increased as a result
of strong external demand and higher production, but the rise was offset by
lower values of cereal exports. In the near term, the quantity of rural exports
is likely to be adversely affected by the unfavourable climatic conditions
experienced recently. The Australian Bureau of Agricultural and Resource Economics
estimates that the volume of total farm production will be 4.6 per cent lower
in the current fiscal year, due to the recent drought in Western Australia
and floods in the eastern states.

Service exports fell in the December quarter, following the Olympics-related boost
in the September quarter. The ABS estimates that the Olympics and Paralympics
added $1,400 million to service exports in the September quarter and $160 million
in the December quarter. Excluding the direct effects of the Olympics, the
value of service exports grew by about 4 per cent in the quarter, to be over
15 per cent higher over the year, driven largely by increased tourism receipts.
Although the Olympics seemed to displace some tourism from Japan, New Zealand and parts of east Asia, arrivals from
these regions have since recovered, while the strong growth in the number of
visitors from the US and EU has moderated.

Manufactured exports rose further in the December quarter, to be 20 per cent higher
over the year (excluding frigates). It is possible that the modest easing in
growth in the latest quarter reflected the moderation in global growth that
has taken place, although the current level of the exchange rate implies that
manufactured exports remain very competitive. Over the past year, growth has
been spread across most major components of manufactured exports. Exports of
telecommunications goods, while volatile, have been at a high level. Growth
in manufactured exports has been quite widespread across all major destinations.

The value of imports grew only slightly in the December quarter and was generally
weak during the second half of 2000. This was consistent with both the significant
depreciation of the currency during the year and the moderation in domestic
demand growth that has taken place. Of these two influences, the exchange rate
has probably been the more significant, as it has contributed to an increase
in the import price index by around 15 per cent over the past year.

Weakness has been evident across each of the major categories of imports, and has
been particularly noticeable for imports of capital goods. Some components,
however, have continued to grow strongly. Changes to the tax system, for example,
contributed to a 30 per cent rise in the quantity of motor vehicles imported
over the year to December. Telecommunications equipment imports also continued
to grow strongly in December, with mobile phones accounting for about half
of the quarterly increase.

The continued strong demand for imported telecommunications equipment is contributing
to the ongoing rise in the share of imports from east Asia (excluding Japan)
(Graph 37). Overall, the value of imports from this region rose by $1.8
billion over the year to the December quarter. Computer and telecommunications
imports accounted for about a third of the increase, and petroleum for a further
quarter.

Graph 37

The net income deficit has continued to narrow, falling from 3.2 per cent of GDP
a year ago to 2.6 per cent of GDP in the September quarter. Combined with the
recent strong growth in exports, this narrowing has implied that the ratio
of net income payments to exports has fallen to around 12 per cent, its lowest
level since the early 1980s.

Australia's net foreign debt increased by 9.6 per cent in the September quarter
to $294 billion, or 46 per cent of GDP. There were sizeable net debt inflows
to the private sector and the depreciation in the Australian dollar increased
the measured Australian dollar value of external debt. Net equity liabilities
fell, largely due to the depreciation increasing the value of equity investments
abroad in local currency terms. Net equity inflows have been fairly weak since
September 1999, especially relative to the preceding two years, reflecting
both lower inflows and greater participation in offshore equity markets by
Australian investors. Overall, net foreign liabilities increased by 3.6 per
cent in the September quarter to around 63 per cent of GDP.

Commodity prices

Commodity prices increased significantly in the first half of 2000, but, in foreign-currency
terms, growth weakened during the second half of the year; over the six months
to January, the Bank's commodity price index increased by around 2 per
cent to be 8 per cent higher than a year earlier (Graph 38). All major
components of the index increased a little over the past six months. Oil prices
have remained volatile.

Graph 38

The movements in the exchange rate over the past year, however, implied that in Australian
dollar terms, commodity prices reached record levels by historical standards
early in the December quarter. Although some of these gains were subsequently
retraced, they remain nearly 20 per cent higher over the year.

The increase in rural prices over recent periods largely reflected concerns that
unfavourable weather conditions in Australia and some other parts of the world
would restrict the supply of rural commodities. Wheat prices increased particularly
strongly in the December quarter, by over 15 per cent in SDR terms. Wool prices,
in foreign-currency terms, were weak early in the December quarter, due to
a run-down in the wool stockpile and reports of higher production, before recovering
quite strongly to be around 12 per cent above the levels prevailing a year
ago.

Most non-rural commodity prices, other than base metals, also rose during the December
quarter, although gold prices remained soft. The price of gold in SDR terms
fell by around 1 per cent. Coal prices have increased particularly strongly
in recent periods, driven by persistently firm demand from Asia and tight supply
in the region. Over the December quarter, prices received for coal increased
by around 8 per cent in US dollar terms, to be 24 per cent higher than a year earlier.

Base metal prices weakened early in the December quarter, before falling inventory
levels led to some recovery. In January, however, they were a little below
levels recorded a year earlier. Aluminium prices fell by around 2 per cent
in the December quarter. Although the prospect of slower global growth placed
downward pressure on prices, the relatively high oil price fuelled expectations
of higher aluminium production costs and lower supply. Copper and lead prices
firmed slightly in January on perceptions that global inventories are quite
low.

Oil prices have varied considerably in recent months. The price of West Texas Intermediate
crude oil was above US$30/barrel until early December, but it then fell sharply
to finish the December quarter about US$3/barrel lower (Graph 39).
Throughout this period, the price of oil was held up by intermittent military tensions
in the Middle East, forecasts of cold weather in the Northern Hemisphere, and
low oil inventory levels. OPEC's production increase in October did little
to ease prices because it was thought unlikely to match projected increases
in global demand. The US release of 30 million barrels from emergency reserves
in November was more effective; it boosted US inventory levels noticeably at
a time when they usually fall. Oil prices dropped markedly in response to this.
Since early January, prices have recovered somewhat, following OPEC's decision
to cut target production by 1.5 million barrels which partially unwinds the
3.7 million-barrel increase over 2000. Oil is currently priced at around $US30
per barrel.

Graph 39

Domestic Financial Conditions

In response to the strength of domestic demand conditions during much of 1999 and
2000, and the consequent risks to inflation, monetary policy was tightened
in a series of steps between November 1999 and August 2000. The increases in
short-term interest rates in that period are likely to have reduced scope for
discretionary expenditures and therefore to have exerted a dampening influence
on domestic demand during the year. The size of the overall interest rate increase,
however, was relatively mild in terms of recent historical experience, with
rates rising from a below-average position in late 1999 to levels that were
close to, or still slightly below, their average for the low-inflation period
(i.e. the period since 1992).

In assessing the overall impact of financial conditions on the economy it is also
important to take account of a broader range of variables including developments
in the financial aggregates, share prices, capital markets and the exchange
rate. Share markets in Australia have held up considerably better than has
been the case in other countries, notably the US. Credit growth in Australia
has been quite strong over the past year and, while it has slowed in recent
months, remains readily available to households and businesses. Businesses
have also continued to have good access to internal funding and to direct financing
from capital markets. At the same time, the lower value of the Australian dollar
over the past year has been providing a strong boost to the export sector.
These developments are analysed in more detail below.

Interest rates

By August 2000, the nominal cash rate had increased by 1½ percentage points
since the start of the recent series of policy tightenings, to 6¼ per
cent, a level marginally above its average during the low-inflation
period (Graph 40). Because the variation
in core inflation during this period was relatively small, conducting the analysis
in terms of the real interest rate makes little difference to that conclusion (see Box B for a more detailed analysis).

Graph 40

While the cash rate is the interest rate in which the stance of policy is expressed,
the more relevant rates for judging the impact on the economy are the rates
that borrowers pay financial intermediaries. As set out in more detail in Box
B, the conclusion that recent levels of real interest rates have not been particularly
high is stronger if the comparison is made using intermediaries' interest
rates. The sharp compression in banks' interest margins over the past five
years or so has meant that the December quarter level of mortgage rates, for
example, was noticeably below its average for the low-inflation period, in
both nominal and real terms. Mortgage rates at end 2000 were also at a lower
level than at the cyclical low reached after the early 1990s recession. As
discussed in the chapter on ‘Domestic Financial Markets’,
interest rates on various fixed-rate loans have fallen quite significantly
in recent months reflecting declines in rates in capital markets.

Comparing the situation with the US, a couple of important differences are worth
noting. The peak in the Federal funds rate in this latest cycle (6.5 per cent)
was higher than that reached in the 1994/95 tightening (6 per cent), whereas
in Australia the most recent peak in the cash rate was well below the mid 1990s
peak (6.25 per cent vs 7.5 per cent).
A similar conclusion would apply if the comparison had been made using real rates
of interest. Tables 8 and 9 give more details of Australian and US interest
rates.

Table 8: Australian Nominal and Real Rates

Cash rate

Mortgage rate (standard variable)

Small business indicator rate

Nominal rates

Dec 2000

6.25

8.05

9.20

Average 1992–2000

5.85

8.56

9.53

Real rates(a)

Dec 2000

4.17

5.93

7.06

Average 1992–2000

3.69

6.34

7.29

(a) Real interest rates calculated using the weighted median inflation rate.
An inflation rate of 2¼ per cent was
used for the September quarter 2000 and 2 per cent for the December quarter
2000.

Table 9: US Nominal and Real Rates

Federal funds rate

Mortgage rate

Business indicator rate

Nominal rates

Dec 2000

6.50

7.38

9.50

Average 1992–2000

4.88

7.76

7.84

Real rates(a)

Dec 2000

3.82

4.68

6.74

Average 1992–2000

2.08

4.89

4.96

(a) Real rates calculated using core inflation.

Another measure of the tightness or looseness of domestic financial conditions is
the shape of the yield curve – specifically, the relationship between
short-term rates, which are set by the authorities, and long-term rates, which
are determined in the market. If short-term rates are higher than long-term
rates, this is sometimes taken to indicate that monetary conditions are relatively
tight.

Such a situation has developed in Australia over the past few months. Before the
recent easing, yields on 10-year bonds had fallen to 5.25 per cent, 100 basis
points below the then cash rate (Graph 41). This was the first inversion
of the yield curve in Australia since the late 1980s, although that was much
greater in magnitude and was caused by a very sharp rise in the cash rate,
whereas the latest episode mainly reflects falling long yields. The latest
episode is more like the situation in 1998, when long yields also fell sharply
as markets became pessimistic about the economic outlook (although subsequent
events proved those concerns to be unfounded).

Graph 41

Financial aggregates

Since the mid 1990s, credit has grown at a solid rate, ranging between about 8 per
cent and 15 per cent(Graph 42).
Growth accelerated toward the top of this range in the first half of 2000, partly
due to the forthcoming introduction of the GST, which saw housing lending,
in particular, rise strongly. Since then, it has slowed, but the current rate
of 8¼ per cent (on a six-month annualised basis) remains within the
range in which it fluctuated during the strong economic expansion over the
second half of the 1990s, and much higher than it was in the recession of the
early 1990s, when credit growth was negative.

Graph 42

Households continue to borrow at a faster rate than businesses, with housing credit
rising at an annual rate of about 11 per cent in the six months to December,
and growth in personal credit around 13 per cent over the same period. Growth
of business credit has slowed noticeably to about 5 per cent (annual rate)
in the six months to December. While there is likely to be some element of
cyclical slowdown here, the slowing in borrowing by businesses from intermediaries
also seems to reflect high levels of internal funding, as profits remain high,
as well as the continuing recourse to direct raisings in capital markets (see
the chapter on ‘Domestic Financial Markets’
for further details).

Credit, broadly speaking, is a measure of assets that intermediaries hold on their
balance sheets. The monetary aggregates are a measure of domestic liabilities
used by intermediaries to fund credit provided to businesses and households.
Prior to deregulation, credit and the monetary aggregates used to move similarly,
being the opposite sides of intermediaries' balance sheets. But, in recent
years, periods of divergent growth have been common as intermediaries found
new ways to fund themselves. Over the past four years, the monetary aggregates
have been extremely volatile. Recently, the monetary aggregates have slowed
sharply (Graph 43). In the six months to December, for example, broad
money grew at an annual rate of about 1½ per cent. A gap between the
growth of credit and broad money has been evident since 1997 and reflects switching
by intermediaries from domestic deposit funding (which is counted in the monetary
aggregates) to foreign sources of funds (which are not).

Graph 43

The pattern of funding of intermediaries' balance sheets over the past six months
is summarised in Table 10. In recent months, they have relied on foreign raisings
to fund almost 60 per cent of the rise in credit; about a further 10 per cent
has been funded in domestic capital markets through domestic bond issues to
take advantage of the low level of long-term interest rates. (Issues of bonds
by banks are also excluded from monetary aggregates.) Only about a third of
new funding in the second half of 2000 came from banks' traditional source
of funds, namely raising deposits in domestic markets. The result has been
that recent growth in domestic deposit liabilities has fallen by noticeably
more than the overall level of financing activity in the economy, of which
credit is the best measure.

Table 10: Movements in Intermediaries' Balance Sheets

$ billion, six months to December 2000

Liabilities

Assets

Deposits

11.8

Credit

33.6

Net offshore raising

19.4

Domestic bonds

3.4

Net other liabilities

−1.0

Total

33.6

33.6

Real exchange rate

As discussed in detail in the chapter on ‘International and Foreign Exchange
Markets’, the Australian dollar fell sharply during 2000, both against
the US dollar and in trade-weighted terms. Since inflation rates in Australia
and in most major trading partners have remained comparably low in recent years,
these movements in nominal exchange rates also translate into measures of real
exchange rates, which adjust for differences in inflation rates across countries.
Graph 44 shows a measure of the real trade-weighted index of the Australian
dollar obtained by adjusting the component bilateral rates for relative movements
in consumer prices. This index fell by around 11 per cent over the year to the December quarter,
in line with the movement of the nominal TWI.

Graph 44

While it is not possible to establish any exact benchmark for evaluating the influence
of the exchange rate on the economy, recent levels of the real exchange rate
have been clearly at the low end of historical experience, and therefore exerted
an overall expansionary impact. The real TWI in the December quarter was 15
per cent below its 1990s average, and slightly lower than previous quarterly
troughs recorded in 1986 and 1995. The appreciation in the nominal exchange
rate in recent weeks will have reversed only a small part of this stimulus.

Box B: Real Interest Rates

Interest rates are often analysed in real, or net of inflation, terms. This takes
account of the fact that part of the nominal interest that borrowers agree
to pay to lenders represents compensation for anticipated inflation. The remaining
‘real’ component better reflects the economic cost of borrowing
and the return to lending.

There are a number of measurement issues that arise in calculating real interest
rates. There is no unique measure of this concept because interest rates vary
depending on such factors as the maturity and risk of the loan or asset. Another
important issue is that measures of real interest rates should ideally be
constructed from expected inflation over the life of the loan or asset. In practice,
however, inflation expectations are not readily observable, and they have
to be proxied either by survey-based measures or by an appropriate indicator
of the current actual inflation rate. For these reasons it is important to
look at a range of measures when assessing the overall impact of real interest
rates on incentives to borrow and invest.

Graph B1 shows two measures of the real cash rate. The first is calculated using
a measure of current inflation (the weighted median inflation
rate[1]
over the year to the time the cash rate is observed) and the second using
a measure of expected inflation (the Melbourne Institute survey of households'
inflation expectations). The real cash rate calculated on the second basis
is consistently the lower of the two, because the survey measure of consumers'
inflation expectations has typically exceeded actual inflation.

Graph B1

The real cash rate measured using current inflation rose by around 1¾ percentage
points from the trough at the end of 1999 to the December quarter 2000. This
measure implied a real cash rate of just over 4 per cent prior to the February policy easing,
only slightly above its average for the low-inflation period since 1992.
The second of the two measures has shown a somewhat different pattern over
the past year. It declined sharply during 1999 and into the early part of
2000, reflecting the temporary upward spike in consumers' expectations
of inflation prior to the introduction of the GST. Subsequently, as inflation
expectations have returned to more normal levels, the implied real cash rate
has moved back up. Nevertheless, this measure too rose to a level only marginally
above its average for the period since 1992. Both these measures of the real
cash rate remain well below the levels reached in the mid 1990s tightening
phase of monetary policy, which in turn were significantly below the peaks
reached in the late 1980s.

Graph B2 shows real interest rates of financial intermediaries for housing and small
business loans, calculated using current inflation rates (corresponding to
the first of the two methods described above). While broadly tracking movements
in cash rates in the short term, these indicator rates have undergone a significant
downward shift relative to cash rates in the course of the past decade, reflecting
the competitive pressures that have compressed intermediaries' net interest
margins over that period. Hence, while intermediaries' real indicator
rates for these types of loans have increased during the past year in line
with the cash rate, they are still relatively low in historical terms. Before
the February easing, real housing loan rates were just under 6 per cent, about half a percentage point below
the average levels over the low inflation period since 1992, and lower than
they were at their cyclical trough in the early 1990s. The compression of
margins on business indicator rates has not been quite as pronounced as has
been the case for housing loans in that period, but these rates also were
slightly below their cyclical average in real terms in December.

Graph B2

Domestic Financial Markets

Market interest rates

For some time following the tightening of monetary policy early in August, market
participants continued to expect further monetary tightening. Reflecting this,
the yield on 90-day bills rose to a peak of 6.65 per cent in late September
(Graph 45). These market expectations subsequently gradually subsided,
but bill yields remained above the cash rate through to end November.

Graph 45

In mid December, the situation began to change. There was growing concern about instability
in US asset markets and the possibility of a slowing in the US economy. Markets
in the US began to expect that the Fed would ease interest rates by its late
January meeting. While commentators drew a sharp distinction between Australian
and US developments, the building expectations of a US easing did start to
have some impact on local markets. By late December, short-term yields in Australia
had moved a little below the cash rate, but this process gathered momentum
after the cut in the US Fed funds rate early in January and, again, after the
favourable domestic inflation news later in the month. By early February, financial
markets had largely anticipated the cut in the cash rate of 0.5 of a percentage
point (to 5.75 per cent) on 7 February, so that short-term yields showed little
further change.

Long-term market yields in Australia have also moved sharply lower in recent months.
They had traded within a range of 6 and 6¼ per cent for much of the
second half of last year. From mid November, however, they began to fall, mainly,
at first, on the back of the fall in yields in the US. Bond yields in Australia
continued to fall in January, however, even though they rose from their lows
in the US after the Fed's move. By early February, the yield on Australian
10-year bonds had moved down to about 5.25 per cent, its lowest level since
April 1999, when yields were rising from the historical lows associated with
the near collapse of the hedge fund LTCM (Graph 46).

Graph 46

Over the past few years, Australian bond yields have shown a very high correlation
with US yields, more so than the correlation of short-term interest rates in
the two countries. It is therefore hard to know the extent to which the recent
fall in domestic bond yields is simply a reflection of US developments. More
generally though, the fall in bond yields in Australia is set against a background
of falling inflation expectations.

The differential between Australian and US 10-year bonds has remained within a tight
range in recent months, between zero and 50 basis points (Graph 47). In
early February, this differential was about 15 basis points, at the low end
of the recent range and very low by historical standards.

Graph 47

Intermediaries' interest rates

Interest rates on the full range of variable-rate loans to households and businesses
remained largely unchanged between the adjustments that followed the last increase
in the cash rate in August 2000 and the reduction of 50 basis points in the cash rate in February 2001
(Graph 48). (There were, however, cuts in banks' ‘honeymoon’
mortgage rates of between 0.5 and 1.0 percentage point.)

Graph 48

On the same day that policy was eased in February, each of the major banks (and some
other lenders) announced that they would cut their standard home loan rates
by the full 50 basis points. The average variable-rate mortgage rate is now
7.55 per cent.

At the time of writing, only one bank had announced a reduction (of 50 basis points)
in its variable-rate loans to businesses.

There have been widespread reductions in interest rates on fixed-rate loans in recent
months. Since November, banks have lowered the interest rate on 3-year fixed
rate mortgages by 0.8 of a percentage point to 6.9 per cent.

The comparable fixed-rate indicator for small businesses has been reduced by slightly
more than housing rates recently. The drop in these rates since their peak
in early 2000 has been larger for small businesses (at 2.0 percentage points) than for households (at
1.1 percentage points) mainly because small business
rates rose by more than mortgages when market interest rates were rising in
1999. The drop in small business fixed rates from the peak has kept pace with
the fall (of about 1.9 percentage points)
in yields in capital markets in which term loans are funded (Graph 49). About
20 per cent of the stock of housing loans
and about 40 per cent of small business loans
are at fixed rates.

Graph 49

Capital markets developments

Debt markets

Funding through capital markets is becoming an important source of credit. About
one-fifth of debt financing used by Australian businesses now comes from capital
markets. While this proportion is a lot less than in the US (where around half
of business debt financing comes from capital markets), capital market developments
are nonetheless an important influence on the availability of credit to borrowers
in Australia.

Unlike in the US, there are no signs in Australia of any tightening in access to
funds from capital markets. In the December quarter, net total debt raisings
amounted to $5 billion, roughly in line with the average quarterly amount raised
in the first three quarters of the year.

Corporate bond issuance in Australia in the first half of 2000 was dominated by recently
privatised utilities (such as electricity distributors and airports) whose
bonds had extra credit enhancements built-in allowing them to be AAA-rated.
More recently, a greater share of issuance has come from less highly-rated
companies. The move down the credit risk spectrum has been accompanied by an
increase in the share of issuance being shorter term (around three years) and
floating rate. For the year as a whole, the distribution of raisings by credit
rating of the borrower and by maturity was quite even (Table 11).

Table 11: Composition of Australian Corporate Bond Issuance in 2000

By rating

By maturity

Credit rating

Share of total(per cent)

Maturity(years)

Total(per cent)

AAA

47

1 to 3

19

AA

6

4 to 5

24

A

34

6 to 7

20

BBB

13

>7

37

Interest rates on corporate debt in Australia have come down sharply in recent months,
and are now down about 1.8 percentage points from a year ago. This has unwound
all the earlier rise that had been associated with the tightening of monetary
policy. This fall in corporate yields has been very similar to that in government
yields. This reflects the fact that credit spreads in Australia, be they for
high-grade or low-grade debt, have not changed much over the past year. For
example, spreads on AAA-rated bonds have oscillated between 45 and 55 basis points since June 2000. This stands in
marked contrast to US developments (see chapter
on ‘International and Foreign Exchange Markets’)
and suggests there has been no deterioration in debt market conditions in Australia.
The level of non-government yields is shown on Graph 50 while the spreads to
government yields are on Graph 51.

Graph 50

Graph 51

With credit spreads in Australia remaining steady and those in the US rising, the
interest rates paid by Australian companies are now significantly below those
paid by US companies. Table 12 summarises the relevant interest rates for companies
of various credit ratings. The gap for less highly-rated companies is particularly
wide.

Table 12: Comparison of Australian and US Bond Yields

Credit rating

Australia
(per cent)

US
(per cent)

Margin
(basis points)

Government debt

5.05

4.90

15

AAA-rated

5.60

5.90

−30

A-rated

5.95

6.45

−50

BBB-rated

6.20

7.10

−90

The one area in Australia where there has been some re-rating of risk by markets
has been in the telecom sector. This has been a common experience around the
world. The international deterioration began around the middle of last year
after telecom companies were seen to have paid excessive amounts for so-called
third generation (3G) spectrum licences. To finance the acquisition of these
licences, the telecommunications sector raised large amounts of debt in corporate
bond markets. The growth in that debt, combined with uncertainties about how
much additional revenue 3G technology will generate, has seen the credit ratings
of telecommunications firms fall and their credit spreads rise.

While Telstra debt has been affected by this, the deterioration in its spread has
not been as marked as that for telecoms in some overseas countries (Graph 52).
Telstra remains at the better end of the spectrum for credit ratings of telecommunication
companies.

Graph 52

One sector where there is a particularly marked contrast between the Australian and
US experience is banking. Spreads on US bank debt relative to government debt
rose to over 100 basis points in late 2000 from 60 a year ago. In contrast,
the spread on Australian bank debt has remained flat, averaging around 60 basis points(Graph 53).
The gap between the spreads widened significantly around the middle of last year,
with the collapse in the high-tech equity bubble, as markets became increasingly
concerned about the extent to which US banks were exposed. More recently, the
policy action by the Fed seems to have calmed markets and US spreads have fallen
somewhat.

Graph 53

Differences in market assessments of Australian and US banks can also be seen in
equity markets, as shown in Graph 54.
Share prices of Australian banks are at historical highs but those of US banks are
still well down on their level of 1998.

Graph 54

Equity markets

The recent falls that have characterised US share markets have not been reflected
in the Australian market. The ASX 200 index has shown little net change since
end September whereas the broad-based US indices have shown net falls of around
9 per cent in this period. While share prices in most other developed countries
have also held up better than the US market recently, the Australian market
is the only one that remains close to its peak.

The recent better performance of the Australian market has allowed it to narrow the
gap to the US market that had opened over the past three years (Graph 55).
If the comparison is extended back to the start of 1995, of course, the increase
in the US share market greatly exceeds that in Australia (the respective increases
being around 175 per cent and 70 per cent).

Graph 55

The main sector accounting for the recent relative strength of the Australian market
is the banking sector, where share prices have risen by 13 per cent over the
past four months. In addition, the resource sector has also been comparatively
strong, rising by 5 per cent.

The pure technology sector in Australia has seen a fall in share prices similar to
that in the NASDAQ, but this is only a very small part of the Australian index.

Share market valuations remain above average in Australia, though less so than in
the US. The commonly used measure of share market valuations – the price-earnings
ratio – rose in Australia from around 15 in early 1995 to 29 in mid 2000.
Since then, it has fallen back to 21 (Graph 56). This fall has come about
not from falls in share prices, as in some other countries, but from rising
profits (including the recovery in BHP's and other mining companies'
profitability). The long-run average price-earnings ratio in Australia is about
15. As noted earlier, the price-earnings ratio for broad US share indices is
currently 25, compared with a long-run average of 16.

Graph 56

Initial public offerings in Australia slowed in the December quarter 2000 but remain
in line with the experience of recent years (Graph 57). The Australian
market had not experienced the earlier surge seen in the US, nor has the recent
slowing been as marked.

Graph 57

Inflation Trends and Prospects

Recent developments in inflation

Consumer prices

The Consumer Price Index increased by 0.3 per cent in the December quarter, to be
5.8 per cent higher than a year earlier (Graph 58). The December quarter
outcome was lower than had generally been expected, and was the result of low
outcomes across a wide range of components. Year-ended growth in the CPI and
the standard measures of underlying inflation continue to reflect the impact
of the new tax system on prices, the bulk of which occurred in the September
quarter (Table 13). Higher petrol prices have also significantly boosted
the headline CPI. While estimates of the tax effects are subject to considerable
uncertainty, the range of available estimates are consistent with underlying
inflation (excluding the first-round effects of tax changes and petrol prices)
being around 2 per cent over the year to the December quarter 2000.

Graph 58

Table 13: Measures of Consumer Prices

Percentage change

Quarterly

Year-ended

September 2000

December 2000

September 2000

December 2000

Headline CPI

3.7

0.3

6.1

5.8

– Tradeables

2.1

0.2

3.4

3.8

– Non-tradeables

5.1

0.5

8.4

7.6

CPI excluding volatile items

3.5

0.2

5.5

5.1

Market goods and services excluding volatile items

3.7

0.3

5.6

5.2

Weighted median(a)

3.6

0.4

5.4

5.2

Trimmed mean(a)

3.9

0.4

5.9

5.8

(a) For details on the calculation of these measures, see ‘Measuring Underlying Inflation’,
RBA Bulletin, August 1994. This is available on our website: <www.rba.gov.au>.

Prior to the introduction of the new tax system, it was expected that the tax changes
would result in a large increase in the CPI in the September quarter, followed
by low increases in subsequent quarters as the removal of embedded wholesale
sales taxes placed downward pressure on retail prices. In the event, the increase
in the CPI over the September and December quarters together was smaller than
expected. There are several possible interpretations of this outcome. It is
possible that businesses have absorbed some of the tax increase into their
profit margins, and are still determining whether to pass these increases on
to consumers. In a low-inflation environment, it may take some time for producers
to assess the appropriate level of their prices following a widespread change
in relative prices, as brought about by reforms such as these. It is also possible
that the original estimates of the long-run tax effects were too high. It was
always recognised that, given the nature of the tax changes, it was not possible
to estimate the magnitude or timing of the net tax effects with precision.
Finally, underlying inflation may have been running at a lower rate than had
earlier been assessed. All of these factors may be at play to some degree,
and it could be another quarter or two before a clearer reading on underlying
inflation becomes available.

A couple of non-tax-related factors that had been boosting inflation over the past
year abated in the December quarter. Petrol prices continued to contribute
to the increase in the CPI, although the 1.3 per cent increase in petrol prices
recorded in the December quarter was markedly lower than the increases recorded
in the previous few quarters. Over the year to December, the petrol price rose
by 24.5 per cent, contributing 1 percentage point to the year-ended increase
in the CPI. Over the course of the December quarter, however, petrol prices
eased as world oil prices fell and the exchange rate appreciated. Assuming
oil prices and the exchange rate remain around current levels, the March quarter
CPI is likely to record a fall in petrol prices for the first time since early
1999. Increases in house purchase costs, which have made significant contributions
to inflation over the last couple of years, also eased in the December quarter
as the housing sector weakened. The house purchase component of the CPI increased
by just 0.2 per cent in the December quarter, after having increased by nearly
14 per cent over the year to the September quarter (including tax effects).

The December quarter CPI showed little effect of the depreciation of the exchange
rate over the previous year. In import-weighted terms, the exchange rate depreciated
by around 11 per cent over the year to the December quarter (Graph 59).
Although the lower exchange rate was passed rapidly through to producer and wholesale
prices (as discussed further below), as well as retail petrol prices, the pass-through
to other consumer prices has been more difficult to detect. Excluding petrol,
tradeable prices were flat in the December quarter and increased by 1.9 per
cent over the year (including the effect of the tax changes). Imported motor
vehicle prices fell by 1 per cent in the December quarter, and prices of other
items with a high import content, namely clothing, audio, visual and computing
equipment and appliances, either fell or increased very modestly in the quarter.
Prices for these goods have either fallen or increased at relatively low rates
over the past year.

Graph 59

The lack of pass-through of the lower exchange rate to consumer prices is suggestive
of a compression of margins in the retail sector, and is thus consistent with
evidence of weaker profits in retailing (as discussed in the chapter on ‘Domestic Economic Activity’).
This may reflect concerns about the strength of domestic demand or competitive
pressures, and it could also reflect businesses' preferences only to pass
through exchange rate changes that are expected to be long lasting. Although
there remains the likelihood that the lower exchange rate will be reflected
in consumer prices in coming quarters, the appreciation of the exchange rate
in the early part of 2001 may have relieved this pressure a little, facilitating
a rebuilding of retail margins without the need for as much adjustment of retail
prices.

Producer prices

Producer prices have increased sharply over the past year, driven by rising world
commodity prices, particularly for mineral fuels and basic metal products,
and the depreciation of the exchange rate. In contrast to the outcomes for
consumer prices, producer prices have increased more rapidly than generally
expected. The most rapid increases have been evident at the earlier stages
of production, with the impact of raw materials prices on final-stage prices
diluted by other factors, such as capital costs, labour costs and profit margins,
which tend to be less volatile than materials costs (Table 14).

Table 14: Producer Prices by Stage of Production

(Percentage change)

December quarter 2000

Year to December quarter 2000

Preliminary

2.9

10.3

Domestic

1.9

7.6

Imported

8.8

27.1

Intermediate

2.6

8.4

Domestic

1.7

6.4

Imported

8.5

21.8

Final

Domestic(a)

0.7

4.1

– Consumption

0.5

4.0

– Capital

0.8

4.0

Imported

5.6

10.6

– Consumption

5.1

11.3

– Capital

6.2

9.9

Total(a)

1.5

5.2

– Consumption

1.3

5.4

– Capital

1.8

5.1

(a) Excluding exports

Final producer prices (excluding exports) increased by 1.5 per cent in the December
quarter to be 5.2 per cent higher than a year earlier. Substantial increases
were recorded in import prices across all industries, largely as a result of
the depreciation of the exchange rate. Domestic price rises were more moderate.
The final-stage index for consumption goods has moved in line with the broader
index, rising by 5.4 per cent over the year. While this index most closely
parallels the composition of the CPI, it places a much higher weight on goods
than does the CPI and is also measured at basic prices rather than retail prices,
that is prior to the imposition of indirect taxes, transport costs and trade
margins.

Sharp rises in the cost of raw materials have driven the rapid price rises at earlier
stages of production. Rises in manufacturing input prices of around 26 per
cent over the past 18 months have, in turn, resulted in higher growth in manufacturing
output prices, which increased by 2.5 per cent in the December quarter and
have increased by 12 per cent since mid 1999. The largest contributors to the
overall increase have continued to be petroleum and coal products and basic
metal products, although the December quarter increase was more broadly based.
Excluding these two items, manufactured output prices increased by 1.3 per
cent in the December quarter. The effect of the lower value of the currency
on the cost of capital goods is evident, with the price of imported machinery
rising strongly in the December quarter.

These rising inflation pressures have been partially offset by modest inflation in
most non-tradeable sectors. The available data for the service sector suggest
that inflation has generally remained subdued, although there have been sharp
rises in prices for international transport and the cost of property services.
Increases in construction costs have moderated. Abstracting from the effect
of removing the WST from building materials prices, price increases for building
materials used in housing construction have slowed sharply in conjunction with
the downturn in the residential construction sector, while the price of non-residential
construction materials continues to rise at a modest pace.

The sharp rise in producer prices, particularly for tradeable goods, suggests some
upstream pressure on consumer prices in coming quarters, but there are indications
that producer price inflation may have passed its peak. Abstracting from the
imported components, the producer price data suggest that prices of domestically
produced items have risen only modestly over the past two quarters, and the
recent appreciation of the currency should also help to lessen the upstream
price pressures.

The recent business surveys provide a broadly consistent picture; they report that
growth in product prices has increased sharply over the past year but some
moderation is likely in the period ahead. The economy-wide NAB survey has recorded
a clear step-up in the rate at which firms expect to increase final product
prices, and expectations are for similar increases in the March quarter to
the increases recorded in the preceding two quarters (Graph 60).
Retailers expect higher price rises, which the survey attributes to an intention
to reverse the recent compression in margins. The ACCI-Westpac survey of manufacturers
recorded a similarly marked step-up in the net balance of firms increasing
their prices over the past year. Purchase costs, which have risen sharply in
recent quarters, are expected to increase at a more moderate pace in the March
quarter, according to both surveys.

Graph 60

Labour costs

The broad range of wage indicators suggests that wages growth has begun to edge higher
after a period of more moderate outcomes. The wage cost index (WCI) rose by
1.2 per cent in the September quarter and by 3.1 per cent over the year, up from the year-ended
rate of 2.8 per cent in the previous quarter (Graph 61). While the quarterly
rise in the WCI was the equal largest in the three years since the inception
of the survey, it may be seasonal: outcomes in the September quarter have,
to date, been larger than in other quarters (the data are not seasonally adjusted).

Graph 61

The size of wage increases provided by new federal enterprise agreements picked up
in the September quarter to an average annualised rate of 4.1 per cent, from
3.4 per cent in the June quarter (Table 15). However, the extent of this
pick-up was boosted by a couple of large public-sector agreements that were
affected by significant renegotiation lags, resulting in the recorded wage
increases being higher than would otherwise have been the case. The average
annual wage increase in private-sector agreements, which may provide a better
guide to emerging wages pressure, has risen from 3.5 per cent to 3.9 per cent
over the past year. Further increases in this series may occur in the next
couple of quarters, as annualised wage increases of between 4 and 4½
per cent contained in recent agreements reached in the Victorian manufacturing
sector are included in the series.

In contrast to the moderate increases shown in other wage measures, average weekly
ordinary-time earnings (AWOTE) have risen very rapidly in recent quarters,
to be 6.1 per cent higher over the year to August 2000 compared with a year-ended
growth rate of 2.1 per cent recorded a year earlier. Notwithstanding the tightening
of labour market conditions during 2000, the extent of the pick-up in wages
growth recorded by AWOTE seems to be overstated. It may partly represent a
correction for the surprising weakness that was evident in this measure of
wages in the latter half of 1999. AWOTE is a measure of the wage bill per employee
and is therefore affected by changes in the underlying composition of employment.
Measures of labour costs reported in the national accounts, which are also
derived from a wage bill, have shown a much smaller acceleration from a little
below 2½ per cent in late 1999 to just below 3½ per cent over
the year to the September quarter 2000. If non-wage costs are excluded, the
pick-up in growth is only slight.

The Mercer Cullen Egan Dell (MCED) salary review for the December quarter reported
that the base salary of executives grew by 4.8 per cent over the course of
2000, up slightly from the average rate of 4.6 per cent recorded in the preceding
four quarters. The base salary component does not include any bonuses or returns
from participation in corporate share schemes. Data from the MCED survey suggest
that the growth of non-executive pay has remained steady at a little over 4
per cent (Graph 62).

Graph 62

The latest business surveys suggest that there is little further upward pressure
on wages growth. The December quarter ACCI-Westpac survey of manufacturers
reported a sharp decline in the net balance of firms finding it more difficult
to find labour. The broader NAB survey reported that the percentage of firms
which cite the availability of suitable labour as a constraint on current output
growth has eased from the high levels recorded in late 1999.

One uncertainty in the wages outlook has been the potential for additional wage increases
triggered by GST-related clauses contained in some enterprise agreements. In
recent quarters the proportion of private-sector employees covered by GST-related
clauses has risen, although it remains relatively low. This increase has been
largely driven by a rise in the number of clauses that seek to reopen wage
negotiations should inflation exceed expectations or some defined benchmark,
rather than clauses providing full or partial indexing of wages to the CPI.
The lower-than-expected CPI outcomes since the introduction of the tax changes
have, however, reduced the likelihood of significant extra wage claims being
generated by this mechanism.

The Safety Net Review of award wages is currently being undertaken by the Australian
Industrial Relations Commission (AIRC). The AIRC will consider an application
by the Australian Council of Trade Unions (ACTU) to increase award rates of
pay from the federal minimum wage ($400.40 per week)
up to $492.20 by $28 per week, and by 5.7 per cent for award rates above this. A
decision is expected in late April.

Inflation expectations

Most broad measures of inflation expectations have fallen in recent months, suggesting
that factors such as the introduction of the GST, higher oil prices and the
lower exchange rate are more likely to have a temporary effect on the inflation
rate than add to ongoing inflation pressures.

Consumers' expectations of inflation, as surveyed by the Melbourne Institute,
have declined since the introduction of the tax changes in mid 2000, to around
the level prevailing in 1998 (Graph 63). The median expectation of inflation
over the next year has fallen from a peak of over 8 per cent in May 2000 to
3.9 per cent in January 2001, its lowest level in two years. The latest decline
is likely to have been influenced by the lower petrol prices prevailing when
the survey was taken in mid January.

Graph 63

Financial market economists revised down their inflation forecasts following the
unexpectedly low December quarter 2000 CPI outcome. The median inflation forecast
of market economists surveyed by the Bank decreased by around ½ of one
percentage point for both the current financial year and the next. For the
year to June 2001, inflation is forecast to be 5 per cent in headline terms
and 2.3 per cent excluding tax effects, and for the year to June 2002, inflation
is forecast to be 2 per cent (Table 16). The median estimate of the first-year
tax effect is 2¾ per cent, and the majority of respondents
expect taxes to have little effect on inflation over the following year. Most
respondents expect further appreciation of the exchange rate and falls in oil
prices over the next 18 months.

Table 16: Median Inflation Forecasts

Per cent

Year to June 2001

Year to June 2002

Aug 2000

Nov 2000

Feb 2001

Aug 2000

Nov 2000

Feb 2001

Market economists(a)

CPI

5.5

5.4

5.0

2.3

2.4

2.0

– Excluding GST

2.8

2.8

2.3

2.4

2.4

2.1

Union officials(b)

‘Inflation’

5.3

6.0

4.5

4.2

4.5

3.5

(a) RBA survey (b) ACIRRT survey

The inflation forecasts of trade union officials, as surveyed by the Australian Centre
for Industrial Relations Research and Training (ACIRRT), have been lowered
even more sharply. Inflation is now expected to be at least 1 percentage point
lower, in both this year and the next, than was forecast three months ago.

Longer-term inflation expectations of financial market participants, measured by
the difference between nominal and indexed 10-year bond yields, have also fallen.
The ¾ of a percentage point fall in nominal bond yields since October,
which outstripped the fall in indexed bond yields, is similar to the sharp
scaling-back of inflation expectations in global bond markets over the period.
These bond yields imply that long-term inflation expectations are currently
around 2¼ per cent, down from around 3¾ per cent a year ago,
but a little above the low levels recorded in 1998.

Medium-term inflation expectations of businesses, in contrast to the other measures,
have been broadly unchanged over the past six months and remain well above
the level prevailing a couple of years ago. The December quarter NAB survey
indicated that around 60 per cent of firms expect inflation to average 3–4
per cent over the next five years, up from 50 per cent in early 1999, and a
little over 25 per cent of firms expect inflation to be less than 3 per cent,
down from over 40 per cent in early 1999. The difference between this and other
measures of inflation expectations may reflect the higher weight that businesses
place on developments in producer prices and purchase costs when forming their
expectations.

Inflation outlook

It has been difficult to gauge the strength of underlying price pressures in recent
quarters. Measures of inflation have been significantly affected by the recent
indirect tax changes, most of which occurred in the September quarter 2000.
The size and timing of these effects on prices have been difficult to determine
with confidence. The introduction of the new tax system also contributed to
heightened levels of activity in some sectors earlier in the year, which had
some temporary inflationary consequences. Excluding the estimated effects of
the tax changes and other temporary factors, such as higher oil prices, the
Bank's assessment is that inflation has probably been running at around
2 per cent over the past year.

Inflation has for some time been expected to increase in underlying terms, reflecting
the buoyant conditions in the domestic economy that prevailed up to the middle
of 2000 as well as some sharp increases in raw materials costs and import prices
over the past year. Recent developments suggest that demand factors are unlikely
to place as much upward pressure on inflation as had been expected a few months
ago. After growing at an average rate of around 4¾ per cent over the
past three years, the economy now seems likely to experience a period of lower
growth, partly reflecting the softer outlook for the world economy.

Rising labour costs also appear to pose less of a risk to the inflation outlook than
previously seemed likely. Our assessment is that wages growth has picked up
a little in recent periods. With conditions in the labour market having eased
in recent months, and consumers' inflation expectations declining to their
lowest level in two years, however, the likely extent of further acceleration
in wages is limited. The lower-than-expected outcomes for inflation in the
second half of 2000 also make it less likely that CPI or GST-related clauses
in wage agreements will be triggered.

The recent strong growth in producer and wholesale prices, however, is still expected
to generate some upward pressure on inflation in the near term. The sharply
lower exchange rate, coupled with higher global commodity prices over the past
year, have contributed to rapid increases in both materials costs and the prices
of imported goods recorded at the docks. Other than for petrol, however, these
price increases are yet to have a discernible impact on retail prices. The
prices of items with a large import component have been relatively subdued
at the retail level, as have been the prices of tradeable items more generally.
Past experience has been that such upstream price pressures typically take
some time to flow through to retail prices, and if they are spread over a long
enough period of time they may have little perceptible effect on inflation
outcomes. The risk remains, however, that the pass-through of these cost increases
could boost inflation noticeably in the next few quarters, although the appreciation
of the exchange rate in the early part of 2001 could act to alleviate some
of this pressure.

Despite the near-term price pressures likely to be associated with import prices
and materials costs, the longer-term outlook for inflation appears to be more
secure than it did a few months ago. Inflation expectations on the part of
financial market participants and consumers have eased further in recent months,
as the near-term outlook for activity has softened and the new tax system has
been bedded down. Compared with three months ago, the risk that the price spike
associated with the introduction of the GST would lead to a step-up in ongoing
inflation has thus receded considerably. These lower inflation expectations
suggest that should a temporary increase in inflation occur, it is less likely
to result in a persistent inflation problem than would have been the case a
quarter or two ago. In addition, it should be noted that petrol prices are
unlikely to contribute to headline inflation in the period ahead in the way
that they have done over the past year. Petrol prices have declined in recent
months and are likely to subtract from the CPI in the March quarter.

Overall, the Bank's assessment is that inflation, abstracting from the temporary
effects of the tax changes and movements in oil prices, is likely to increase
only slightly in the near term and will remain well within the 2–3 per cent target during the next couple
of years. On a year-ended basis, headline CPI inflation will continue to be
held up by the net effects of the new tax system until the middle of 2001.
It is then expected to fall a little below underlying measures of inflation,
reflecting an assumed further easing in world oil prices and the scheduled
removal of some additional indirect taxes.

This outlook is based on the standard technical assumption that the exchange rate
remains around recent levels, an assumption that is clearly subject to uncertainties
in both directions. Also uncertain is the speed at which the upstream cost
and price increases that have already occurred will feed through to retail
prices. It is possible that a more significant pass-through of these increases
will occur than is currently assumed. An important additional source of uncertainty
concerns the outlook for growth in the global economy. Recent assessments of
likely growth in the world economy have shifted noticeably lower, and there
remain further downside risks in that area, although recent monetary policy
actions will obviously be working to offset those risks. If there were a significant
further weakening in the global economy, it would probably entail somewhat
lower inflation prospects both in Australia and abroad.

Footnote

Footnote Box A

This box focuses on June balancing companies, which account for the bulk of company
tax collections. Similar arrangements apply to companies which balance at
other times of the year. The analysis abstracts from changes in the company
tax rate, which was lowered from 36 per cent
to 34 per cent on income earned in 2000/01.
[1]

Footnote Box B

An inflation rate of 2¼ per cent was used for the September quarter 2000 and
2 per cent for the December quarter and the latest estimate.
[1]